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US mortgage giants were placed on credit watch. Here’s what that means for home buyers

<i>Joe Raedle/Getty Images</i><br/>In this aerial view
Joe Raedle/Getty Images
In this aerial view

By Anna Bahney, CNN

Washington, DC (CNN) — The credit ratings of US mortgage giants Freddie Mac and Fannie Mae were put on watch for possible downgrade by Fitch Ratings late Thursday. A downgrade is not expected to happen, as a deal to resolve the debt ceiling standoff continues to be worked out in Washington, but even the warning is having an impact on mortgage rates.

The warning came because the ratings for Fannie Mae and Freddie Mac are linked to the sovereign rating of the United States. The watch is a result of the ratings agency warning on Wednesday that America’s credit rating could be downgraded if the debt limit showdown was not resolved soon.

Fannie and Freddie, which guarantee roughly 70% of the country’s mortgages, do not directly issue mortgages to borrowers, but instead buy mortgages from lenders and repackage them for investors. They are each a government-sponsored enterprise, or GSE, chartered by Congress.

The aim of Freddie and Fannie is to provide liquidity into the mortgage market and enable a reliable flow of affordable funds to mortgage lenders. This ultimately allows more homeowners to borrow at more affordable rates.

The enterprises buy loans from lenders, pools them and sells them as securities to investors. Because they are backed by the government, these securities are viewed as less risky than other investments and considered to be as creditworthy as the US government.

But this flow of funds could be disrupted if the United States defaults on its debt, Fitch warned.

Fitch’s warning

Placing the GSEs on watch for a downgrade, a status Fitch calls “rating watch negative,” is a direct result of uncertainty about the United States fulfilling its debt obligations and concern about the level of support the housing GSEs can expect if the US rating were to drop.

But, Fitch added, if it were to downgrade the US sovereign due to debt ceiling challenges, it would not necessarily lead to an immediate downgrade of the housing GSEs’ ratings — so long as the housing GSEs continued to perform on their respective obligations.

Fitch notes that the GSEs primarily cover their obligations with cash flows from operations, as opposed to direct reliance on the federal government.

“The housing GSEs continue to benefit from meaningful financial support from the U.S. government,” the Fitch statement said. “Fitch aligns the GSEs’ ratings to the U.S. rating due to their mission-critical function to the U.S. housing finance system and the U.S. Treasury’s Senior Preferred Stock Purchase Agreement. Fitch believes Fannie Mae and Freddie Mac continue to execute on their mission to provide liquidity, stability and affordability to the housing finance industry.”

Under the stock purchase agreement, Treasury is required to inject funds into Fannie Mae and Freddie Mac to keep each firm from being considered technically insolvent by their government conservator, the Federal Housing Finance Agency. At the end of March, Fannie Mae’s net worth was $64 billion and Freddie Mac’s stood at $39.1 billion. The current version of the agreement allows the GSEs to retain funds until they each meet minimum capital levels that would meet requirements for them to exit government control.

Impact on the housing market

Already, the announcement is having an impact on mortgage rates, sending them higher as 10-year Treasury yields — which mortgage rates mirror — climbed on Friday.

“What Fitch is doing is providing a stark reminder of the problems that a default will cause us throughout the economy,” said Melissa Cohn, regional vice president at William Raveis Mortgage.

A recent Zillow analysis of the impact on the housing market of the US defaulting on its debts revealed home purchase costs could spike by 22% and mortgage rates could spike over 8%.

Even though a US default and a downgrade of Freddie and Fannie are not likely to happen, there is a scenario where the US government defaults and is unable to provide necessary support to the enterprises.

Much of the funding for GSEs comes from its own operations rather than government support, but, Cohn said, if mortgage rates spike and there is less revenue coming in to Freddie and Fannie, they might need that funding.

“If rates go to 8% or above? The volume of home purchases would just stop, it is kind of scary,” said Cohn, adding that because so may current home owners have ultra low mortgages of between 2% and 4%, buying a home at 8% would crush their purchasing power.

But a downgrade can be averted, Fitch said in its statement, if there is a resolution.

And for the typical home buyer looking at houses and trying to get a good mortgage rate, a deal reached soon will be the best outcome.

“The typical home buyer is focused on finding a home — if they qualify for a mortgage — knowing what they need to compromise on, contract negotiations and the end-of-month payment,” said Jessica Lautz, deputy chief economist and vice president of research at National Association of Realtors.

“While politics are at play, the ratings watch is a just that — a watch,” she said.

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