Bad Begets Worse

Economy.com projects that this tighter credit alone will account for a 5 percent decrease in housing prices. Overall, Economy.com projects a 30 percent drop in prices.

To sell homes in such a sluggish market, realtors have had to lower prices. When prices fall, homeowners with high mortgage payments tend to walk away from those payments in larger numbers and housing speculators fail at higher rates. Both factors lead to more frequent and more expensive defaults, which hurt Fannie Mae's and Freddie Mac's bottom lines by forcing them to put more money into their capital reserves.

This rise in defaults is a major cause of the companies' net losses, which have been a combined $14.9 billion over the past year.

Those losses reduce investor confidence and compel the firms to be even more conservative about the loans they fund.

The vicious cycle starts all over again.

And the red ink is likely to continue. Earlier this month, Freddie Mac reported that its losses from foreclosures and other failed home loans nearly doubled in the second quarter from the previous three months to $2.8 billion, and that the company more than doubled its reserves for anticipated losses because of delinquencies. One reason: It predicted that national home prices would decline by an average 18 to 20 percent, more than the 15 percent the company had forecast previously.

At Fannie Mae, losses from foreclosures and other problem loans rose to $5.3 billion in the second quarter, from $3.2 billion in the first quarter. And in July, the challenge grew even steeper, said Daniel H. Mudd, Fannie Mae's chief executive. A market that "many of us had already described as the worst in a generation took a turn for the worse after the quarter ended," he said, citing even higher defaults and sharper declines in home prices.

Yesterday, shares of Freddie Mac continued to fall, declining 2.8 percent to close at $3.16. But Fannie Mae stock reversed its sharp decline of earlier in the week, gaining 10.2 percent to $4.85.

Still, industry analysts see a heightened possibility that the federal government will be forced soon to bail out Fannie Mae and Freddie Mac -- an action that might halt or slow this downward spiral.

In a rare display of bipartisanship this summer, the Bush administration and Congress quickly came together on a rescue plan that would prop the companies up if they faced imminent collapse. Treasury was given the authority to lend Fannie Mae and Freddie Mac money or buy stakes in the firms.

Deborah J. Lucas, a finance professor at Northwestern University, said the government's rescue plan was designed to restore confidence in the companies and the financial markets, of which the mortgage market is a significant part. "The motivation for the bailout was to prevent that type of spiral," she said.

So far it has not worked out that way. "Their ability to lend is constrained by their insufficient capital, higher spreads and investor doubts about whether they will be allowed to continue to operate in a business-as-usual mode," Lucas said.