Fannie and Freddie Problems Show Collapse of Old Finance Regime

The old financial system that drove the real estate market to extreme highs in 2005 and 2006 showed further signs of collapse this week with the news that Fannie Mae and Freddie Mac were nearing insolvency. Both of these quasi-governmental organizations played a key role in providing the money necessary for homeowners to pay ever higher prices to purchase homes they could not afford.

At its simplest, both of these organizations worked by buying loans from banks, repackaging them as mortgage backed securities, and selling them to investors across the world. They played a central role in the securitization of mortgage debt.

At the time, they were viewed as institutions that promoted home ownership by making it easier to acquire a loan. A bank could lend more money because it was always assured that Fannie and Freddie would buy the loans. This provided the banks with additional capital and removed them from the bank's balance sheets.

But now, Freddie and Fannie are stuck with a sick pile of mortgage debt and a rising cost of financing. Not only are the morgages which underwrite the mortgage bonds going bad as homeowners get into trouble, but the cost to issue more debt and raise additional funds has become prohibitive.

So how does this impact you? As Fortune writes:

"If Fannie or Freddie failed, it would be far worse than the fall of [investment bank] Bear Stearns," says Sean Egan, head of credit ratings firm Egan Jones. "It could throw the economy into depression or something close to it."

To save Fannie or Freddie could cost taxpayers in excess of $1 trillion according to the article. If they fail, it will destroy the entire mortgage market, making it much more difficult to get loans, raising interest rates, and further depressing housing prices.

While the companies will certainly not be allowed to collapse, in any scenario the result will be scaled back or revised operations that will tighten up lending standards across the country. This will lead to higher interest rates on mortgages and further depress real estate prices.