Curtains for the American Dream?

As much as homeowners have suffered throughout the housing crisis, falling prices were starting to make buying a home increasingly attractive for those disciplined folks who had stayed on the sidelines this long. But the latest bad news from the financial industry may mean fundamental changes to the way people get mortgages for their homes.

Concerns over the solvency of government-sponsored entities Fannie Mae (NYSE: FNM  ) and Freddie Mac (NYSE: FRE  ) caused share prices of those companies to free-fall on Friday. That's bad news not just for shareholders. A failure of these entities could have far-reaching effects on the entire mortgage industry -- which is why the U.S. government is working so hard to find ways to support them.  

Why should I care?
If you're still in the dark as to why government-sponsored enterprises (GSEs) like Fannie and Freddie are any more important than some of the other mortgage-related institutions that have faced serious problems -- such as the subprime lenders and recently bought-out Countrywide Financial -- you need to know what the typical process has been in the mortgage market in recent years.

Before GSEs existed, getting a mortgage meant that you had to find a primary lender, typically a bank, that was willing to lend its capital to you. Generally, the transaction stayed between you and the bank: The bank held the mortgage as an asset on its books, and you made regular payments directly to the bank to pay it off over time.

In the 1930s, mortgage markets started malfunctioning. The amount of capital that mortgage lenders had for loans varied widely across regions, so if banks in a particular area didn't have enough deposits to make mortgage loans, then people who lived there had a lot of trouble getting them.

The secondary market and you
In response, Fannie Mae was created. Joined later by Freddie Mac, they both provide a secondary market for mortgages, freeing up local capital for other loans. Rather than having to keep mortgage loans on their own books for as long as 30 years, banks can simply turn around and sell those loans to GSEs and other buyers on the secondary market. That allows them to conserve and redeploy capital, either for more mortgage loans or other types of financing.

GSEs, in turn, package many of the mortgages into mortgage-backed securities and sell them to investors. However, the GSEs guarantee that if the underlying loans don't pay out as expected, the GSEs will supplement the payments to investors as needed.

Riskier banks
Without GSEs to help facilitate the secondary market in mortgages, lenders would face unappetizing alternatives:

  • If lenders continue offering traditional 15- and 30-year fixed mortgage loans, they'll be forced to retain considerable interest rate risk. If rates rise, they could be stuck with low-rate loans for a long time.
  • Lenders could eliminate rate risk by offering only adjustable-rate mortgages. But borrowers who've already been burned once by rate resets are unlikely to like that option.

Moreover, no matter which type of mortgages a lender chooses to make, if it can't sell loans into the secondary market, the lender will bear the full credit risk itself. Unfortunately, that's a risk many banks may not want to take on, especially in light of the huge increases in reserves they've made for existing bad loans:

Bank

Loan Loss Provision

Increase Since 2006

U.S. Bancorp (NYSE: USB  )

$1.1 billion

102%

PNC Financial (NYSE: PNC  )

$458 million

269%

BB&T (NYSE: BBT  )

$600 million

150%

KeyCorp (NYSE: KEY  )

$672 million

348%

Regions Financial (NYSE: RF  )

$689 million

384%

Source: Capital IQ.

To prevent further losses, banks would likely use very stringent lending standards before making mortgage loans directly to consumers -- loans they'd potentially have to hang onto for decades.

Be an attractive borrower
Whether Fannie and Freddie go down in flames or not, there are things you can do to get a mortgage to capitalize on the lower costs of home. Simply put, the better you look as a borrower, the more likely it is that a lender will make you a loan. That means saving for a down payment, getting your credit score up, and looking at reasonable homes that leave you a margin of safety if a financial emergency arises.

For many prospective homeowners, that's a tall order. But with financial discipline, you can keep your American dream alive -- even in the face of hard times.

To learn more about the financial crisis, read about:

U.S. Bancorp and BB&T are Motley Fool Income Investor recommendations. Find out which banks our income-investing newsletter believes will come out of the financial crisis with flying colors by taking advantage of our 30-day free trial offer. There's no obligation to subscribe.

Fool contributor Dan Caplinger thinks his bank held onto his mortgage, but he's not quite sure. He doesn't own shares of the companies mentioned in this article. The Fool's disclosure policy won't leave you out on the street.


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