The question on the minds of both investors and mortgage banking executives as this week comes to a close is one they never thought they’d ask: what if Fannie and Freddie aren’t the answer? It’s a scary thought. The two government-sponsored entities have been charged with ensuring liquidity in the secondary market for mortgages, a mission that has become critical to the U.S. housing market as the country endures its worst housing slump since the era of the Great Depression. It’s a role the GSEs have played before, but never on such a grand scale — and never with so much of the nation’s economy riding on their collective backs. And, up until now, theirs has been the only part of the mortgage market that’s still working. Which explains why everyone is running headlong into orginating for the conforming market, or attempting to expand the definition of what conforming loans should be. This week, Housing Wire was among the media that reported yield spreads on agency-backed mortgage bonds had reached levels not seen in more than 20 years, as the prices of mortgage-backed securities guaranteed by Fannie Mae and Freddie Mac plunged. Regardless of the myriad of reasons likely driving the price drop, one fact remains crystal clear: the GSEs’ collective ability to keep the mortgage market moving has diminished, even if only for the short term and even if just the result of frenzied deleveraging by hedge funds and other investors on Wall Street. The result? Higher mortgage rates. One industry source, with more than 25 years in mortgage banking, told Housing Wire yesterday that borrowers should get accustomed to higher-rate mortgages. “We’re headed back to 10 percent,” the source said, who asked not to be named. “And that’s going to change the complexion of this industry dramatically.” Both Fannie Mae and Freddie Mac accounted for a record 76.1 percent of new mortgage-backed securities issued in the fourth quarter, a number than industry sources say is likely to reach well above 80 percent to start 2008. Some have even suggested that the GSEs may end up owning as much as 90 percent of the lending market before this year is out. But what if Fannie and Freddie fall victim to the same sort of crisis of confidence that has utterly paralyzed the private-party market? What if losses continue to mount, and the GSEs are forced by Congress to take on riskier and riskier loans? The idea that the GSEs might not be enough seemed almost laughable even one month ago; yet now, it’s that thought that most often sits in the back of nearly every industry participant’s mind. The WaPo reports:

“The implications are quite onerous because this was the one market that was functioning, and moreover, this is the market that the administration was counting on to maintain its liquidity so that it could help all these troubled homeowners,” said Douglas A. Dachille, chief executive of First Principles Capital Management. “If this continues, this is going to be very bad for home prices,” Dachille said.

Not that is isn’t already very bad for home prices, of course. But the thought that things could actually get worse? Not many in the industry want to go there. “Imagine a sinking ship with only two lifeboats, and that the sinking ship would need closer to 50 lifeboats for everyone on board,” said one source, a manager at a large independent lender who asked not to be named. “Those two lifeboats may be the best on the planet, but it won’t matter much if everyone tries to pile onto them, which is exactly what’s happening right now.” The mortgage industry as Titanic? Now that’s a scary thought, indeed.