How Fannie and Freddie reign over the US economy

Fannie Mae and Freddie Mac Crisis

Photo Credit: Don Ryan / Associated Press

The sub-prime mortgage troubles continue to haunt the American economy, even after heating up tremendously just in the past quarter. As America’s banks fight with insolvency and a lack of credit, two mortgage powerhouses are also on the brink of going under. Fannie Mae and Freddie Mac have a combined control of $5 trillion of loan debt, although are only backed by $81 billion in cash. If just 1% of their assets were to be wiped away, the two would sit on $50 billion in losses. It’s easy to see how an economic downturn so heavily weighs on their business.

Low reserve, less safeguard

Traditional banking institutions are required to have a reserve requirement of 10%; thus, $5 trillion in mortgages should be backed up with at least $500 billion in reserve. Since the pair have less than $81 billion on hand, they’re leveraged six times greater than other lenders would ever consider. All of this stems from little regulation of corporations that are government sponsored and eventually government backed.

Lawmakers are quick to extend lines of credit to Freddie and Fannie because of their importance in the US economy. Without the firms’ presence in buying loans, it is believed that many people may have problems purchasing homes on credit. Middle credit score borrowers will likely be the most impacted; high score borrowers can still get prime rates and low score borrowers make up most of the subprime problem.

Falling home prices are a major catalyst

The biggest problem facing Freddie and Fannie are falling home prices. As home prices drop, people are finding it harder to liquidate and cut their losses on falling property values, thus creating the endless cycle of dropping prices and greater supply. You see, as the value of homes drop, more people enter foreclosure and continue pushing down prices. Because foreclosures can take up to 18 months to complete, most of the homes have yet to hit the market either on auction or sale, and therefore, these foreclosures have yet to add to the mess.

When foreclosed homes do make it to market, they generally sell for prices considerably lower than their actual value. While a modest foreclosure level does not do much to home prices, high foreclosure rates create a exponentially growing supply of homes. A greater supply means more months on the market, falling prices, and even more foreclosures.

Two solutions for a terrible problem

The two solutions to Fannie and Freddie’s issue are polar opposites. The extreme left is pulling for a near nationalization of banking, as well as new regulatory measures to control how lenders do business. The right wants to let the market solve the problem by allowing lenders to fail and the market crumble. From the economic point of view, a bailout will delay the problems until the next housing bubble while the laissez faire approach would likely push home prices even lower, impacting this generation, but unlikely to continue for very long.

In any example, it has been concluded by most economists and analysts that a real estate recovery may not happen until late 2009 and even 2010 as the most dangerous mortgages are wiped out of the system and prime borrowers continue making payments. The Federal government passed a new package that would extend Freddie and Fannie unlimited lines of credit and the option of government investment into home loans; while this may bring the housing market back to good terms, it will come at a gigantic cost to US taxpayers.

The premise of Freddie and Fannie entering the point of insolvency is likely to stir the pot a bit more. Freddie and Fannie generally deal with better borrowers than other banks, giving them some kind of relief that the mortgage crisis may not affect them as greatly as other banking institutions. But it is impossible for the pair to get through this mortgage fallout without some scrapes and bruises; the two lost more than $11 Billion in just the past year.

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