Mortgage giants falter

Trouble at Fannie Mae and Freddie Mac could have broad impact.

Their odd names hint at something significant: Fannie Mae and Freddie Mac aren't ordinary corporations, and when they're in trouble, the whole US economy takes notice.

It's not an exaggeration to say that the cost of mortgages, the value of people's homes, and even America's path through the current economic slowdown all hang to some extent on these mammoth conveyors of credit.

And they are in a tough spot.

They have a federal mandate to make sure mortgage loans keep flowing. Yet with the US in the throes of a historic housing downturn, both corporations are losing money.

These are not federal agencies, but suddenly talk of possible taxpayer bailouts is in the air after a big plunge in their share prices last week.

Such a bailout is unlikely, and talk of a crisis is premature, say some experts. But even so, the problems at Fannie and Freddie could well push mortgage costs higher – and make it harder for the housing market to recover.

"They're clearly in deep trouble," says Mark Zandi, chief economist at Moody's Economy.com in West Chester, Pa. "It does highlight the severity of the housing downturn. It's a problem for every homeowner."

In fact, the sudden erosion of investor confidence in these giant enterprises symbolizes one of the economy's great risks – that of a downward spiral in which the housing slump weakens financial institutions and then their problems bounce back and cause still more weakness in the economy and in home prices.

One new sign of the housing market's challenges: On Friday federal regulators seized the faltering mortgage lender Indymac. It will rank among the largest bank or thrift-institution failures in American history.

Throughout the industry, moreover, rising loan losses are impairing the ability of many banks to extend new credit.

Although Fannie and Freddie don't directly make home loans, they are the players who enable a key step in the life cycle of most mortgage loans: resale from the original lender to another institution or to investors. These rival twins either buy loans or guarantee their quality so that other investors will buy them.

Together, the loans they hold or guarantee exceed $5 trillion, or about half the balance of outstanding US mortgages. They're involved in an even greater share of all loans being originated in the current tough market.

When investors or lenders see higher risk – whether at Fannie and Freddie or at mainstream banks – they want something in return. That translates partly into higher mortgage rates, experts say.

And investors do see high risk. Fannie and Freddie each lost about half their stock market value during last week's trading.

"Mortgage rates would be lower now if we didn't have the amount of risk priced into the credit markets that we do," says Michael Darda, an economist at MKM Partners in Greenwich, Conn. "The stock market in general ... is telling us that there are still tremendous strains on the [banking] system. That's going to be a headwind to the economy for the balance of the year."

The typical mortgage rate on a 30-year loan remains relatively low, at about 6.3 percent, according to Freddie Mac. But that's up from about 5.8 percent in January. A range of factors affect mortgage rates - and in this case rising expectations of inflation – have probably played a role as well.

Fannie and Freddie are more important to the economy than most financial institutions. They are also by some measures more at risk.

Financial firms hold reserves of capital to prove their ability to weather storms. A bank typically has a leverage ratio of about 10 to 1, making perhaps $10 in loans for every dollar of capital. Regulators have allowed Fannie and Freddie to have higher ratios, in part because their business practices have been considered low risk.

"They are very highly leveraged," Mr. Zandi says. Their assets may be 30 times capital or greater, he says, "depending on how you do the math."

And in today's housing market, with rising delinquencies and falling home prices, even the safer sides of the mortgage business carry risks. A$5 trillion book of business leaves lots of room for losses to seep into quarterly reports.

A key concern for Fannie and Freddie shareholders: how much new capital the firms will need and whether they'll be able to raise it without government help. By some estimates, they may need $75 billion in new money.

They can raise capital by reducing dividends or by tapping private investors. The expectation of such moves – and the risk of a worst-case scenario in which a government rescue effectively wipes out private shareholders – has hurt the value of current shares.

But many experts say it's far from clear that a formal rescue will be needed.

"We are not in a crisis at this point," says Susan Wachter, a mortgage market expert at the University of Pennsylvania's Wharton School. "This is a moment of lack of confidence."

One positive sign: The companies so far have been able to continue borrowing as usual to fund their operations.

On Friday, statements from government officials and the companies themselves sought to quell public anxiety. Share prices closed far above their lows of the day.

Sen. Charles Schumer, a New York Democrat involved in congressional oversight of the industry, said the firms' "fundamentals, as they look now, provide no reason to think they will fail."

If federal support became necessary, he added, it could come in ways that are much less extreme than a government takeover. That may be of only modest comfort to investors, but such statements do offer some important reassurance for the economy.

"Mortgage markets will keep functioning," whether government help is needed or not, Ms. Wachter says. Still, she says, the trials at Fannie and Freddie have already pushed up mortgage interest rates somewhat for all Americans.

"It makes mortgages more expensive and harder to get," she says. If their finances weaken, "there would be higher costs in the short run and maybe even for the long run."

If loans cost more, that challenges a housing market that already has unusually large inventories of homes for sale. Ultimately, it pushes home values down for all homeowners, because the pool of buyers can't afford to bid as much on houses.

"This certainly delays the day when the housing market turns the corner," Mr. Zandi says. He sees significant risk that the trends of tightening credit conditions, rising unemployment, and runaway mortgage defaults feed on one another and deepen the economy's slump.

"You may not want to let this drag on," he says, suggesting that policymakers try to tame rising defaults and record foreclosures.

The Senate voted Friday in favor of one such measure, designed to allow many at-risk loans to be refinanced, with government insurance, so that cash-strapped borrowers don't default.

It's not clear whether the measure will make it into law.