Freddie Mac and Fanny Mae might be catchy nicknames for lending organizations, but the hole they have dug for themselves is sufficiently deep for it to affect the Federal Reserve’s decision on whether or not to raise the federal funds rate in early August.

By definition, the business that Freddie Mac (more formally, the Federal Home Loan Mortgage Corporation) and Fanny Mae (the Federal National Mortgage Association) does is more open to exposure from bad debts. The two organisations purchase mortgages from banks on the secondary market, pool them, and sell them on to investors as mortgage-backed securities (MBSs).

Freddie Mac and Fanny Mae only purchase (and on-sell in the form of MBSs) so-called “conforming loans”. These are loans that fall below a certain dollar value as set by regulators. Because these loans are “conforming”, it is easy for banks to sell them on to Freddie Mac and Fanny Mae (ie to access more funds that can be loaned out again). As a result, conforming loans typically have lower interest rates than the sub-prime loans, as they are lower risk and are easier to on-sell.

These two organisations charge a risk management fee, but guarantee that they will repay principal and interest earned by investors. In other words, they allow investors risk-free investment in mortgages, albeit at a discount. They can do this because they are government-sponsored enterprises (GSEs).

The upper limit of what constitutes a conforming loan, in dollar terms, is based on the change in average house prices from October to October.

The problem now is that, as house prices in the US fall, and an economic downturn sets in, there is a greater likelihood that even “safer” conforming loans will default. Many are worried that Freddie Mac and Fanny Mae may not be able to pay back the money they owe investors. The two organisations have around $81 billion in capital, but this is just 1.6% of the total debt they insure.
And because Freddie Mac and Fanny Mae have traditionally been “safe as houses”, a large number of their investors are other financial institutions, who in turn have their own investors who could lose out. The fear is basically that the dominoes are lined up, and the biggest dominoes of all are teetering.

Now there is talk of the government placing the two organizations in conservatorship, whereby any losses on mortgages they guarantee will be covered by taxpayers’ money. Considering the two have already lost more than $11 billion in recent months, this will be no small figure.

At this stage, this possibility is still in the “maybe” category, meaning that, as panic spreads, talk of the Fed tightening monetary policy in August to pull back inflation (which stood at 3.6% in May) is losing traction. The bigger concern is that the entire financial system will collapse, particularly if the government does not bail out the two organizations in a timely manner. This means that rather than raising rates to reduce spending and trying to stem inflation, the Fed may be forced to leave rates where they are just to ease concerns over access to credit at a reasonable price.