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Bad Begets Worse

By Jeffrey H. Birnbaum
Washington Post Staff Writer
Friday, August 22, 2008

Fannie Mae and Freddie Mac are giants of the mortgage finance industry. But to investors, they're rapidly shrinking.

And as they struggle, they're taking the housing market with them, reinforcing a downward spiral in which their troubles translate into pricier home loans and increasing foreclosures, in turn further undermining the companies.

"Right now you have a giant negative feedback loop," said Paul Miller, an industry analyst at Friedman, Billings, Ramsey Group. "How you break it, I don't know."

About 70 percent of newly issued mortgages are owned or guaranteed by Fannie Mae and Freddie Mac. Without this financial backing, the banks and other lenders who typically make home loans would no longer be able to do so. The housing market could collapse.

The two companies have tried to keep providing financing to the industry but their mounting losses, rooted in the subprime mortgage crisis, are making this harder and harder. Many prospective home buyers are stuck.

"Fewer people are willing to buy property, which contributes to a decline in housing prices and that leads to more foreclosures and higher losses, which hurts Fannie Mae and Freddie Mac, which pull back by tightening their mortgage terms, thus continuing the cycle," said Robert E. Litan, an economist at the Brookings Institution.

Moody's Economy.com estimates that interest rates on 30-year fixed mortgages are already higher by at least a half percentage point -- and maybe a full percentage point -- because Fannie Mae and Freddie Mac have been forced to pay a premium interest rate on the money they borrow from investors worried about the firms' health.

The yield on bonds guaranteed by the companies has increased to almost the highest in 22 years relative to Treasurys, according to Bloomberg News. And when Fannie Mae and Freddie Mac pay more to borrow that money so they can acquire or guarantee mortgages, the companies pass the cost on mortgage lenders, who in turn charge borrowers more for home loans.

Despite the Federal Reserve's effort to lower interest rates, including repeated cuts over the last year in the interest rate the Fed controls, 30-year, fixed-rate mortgages this week averaged 6.37 percent, the highest level in six years.

At the same time, the companies are tightening credit in an effort to ensure the loans they make will be repaid.

Freddie Mac, for instance, no longer finances no-money-down mortgages, nor does it continue to buy or guarantee mortgages given to people who have failed to document their finances. Fannie Mae has withdrawn from the market for all-day loans, which are considered risky because they require less documentation than traditional prime loans.

As Fannie Mae and Freddie Mac tighten credit and the cost of borrowing increases, the housing market contracts. For the week that ended Aug. 15, the Mortgage Bankers Association reported that applications for new mortgages declined 34 percent from the year earlier to the lowest level since 2000.

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