The credit squeeze is likely to get significantly tighter after Freddie Mac, America’s second-biggest provider of mortgage financing, announced its largest quarterly loss to date on the back of $4.8 billion (£2.3 billion) of bad debts and writedowns in the third quarter.

Freddie Mac’s woes will deal a significant blow to the mortgage market in the United States, where it is a key determinant of liquidity, and will further infect the troubled credit markets, which are closely aligned to America’s housing fortunes.

The damage is expected to be particularly severe because the losses emerged only 11 days after Fannie Mae, America’s biggest provider of mortgage finance, reported that its third-quarter loss had more than doubled, to $1.39 billion.

Freddie Mac and Fannie Mae buy existing home loans from mortgage lenders. The mortgage lenders use the cash raised to lend to more home owners. This process, known as the secondary home-loan market, means that Freddie Mac and Fannie Mae own or guarantee about 40 per cent of America’s $11.5 billion of outstanding mortgages, making them by far the biggest source of home loan financing.

The inevitable decline in secondary home-loan purchases that will result from Freddie Mac and Fannie Mae’s dwindling fortunes will feed through the system to severely hamper the availability of mortgages, reducing demand for houses and pulling prices down even further.

The decline in house prices will push up defaults – as the option of refinancing is closed off to some borrowers – and lead to a fresh round of losses on mortgage-related investments, as their valuations fall.

Since many of these investments are held by banks and hedge funds, these value declines will hamper their ability to lend money across the board, thereby fuelling the broader credit crunch.

Freddie Mac and Fannie Mae make most of their money from packaging the mortgages they buy into bonds and guaranteeing their interest and principal payments, irrespective of defaults on the underlying home loans. They get a fee for guaranteeing the bond payments, but when defaults are high these are more than wiped out as they are left to carry the can.

The two groups also hold mortgages and mortgage-backed securities.

Freddie Mac said yesterday that it was forced to set aside $1.2 billion for bad loans in the third quarter, while it reported a $3.6 billion decline in the value of other mortgage-related assets. This took the group to a $2.02 billion loss and left its so-called core capital only $600 million above the regulatory requirement.

As a result, Freddie Mac appointed Goldman Sachs and Lehman Brothers to advise it on ways to boost its capital, which include a 50 per cent dividend cut in the fourth quarter.

The worse-than-expected results sent the group’s shares down by $10.76, nearly 29 per cent, to close at $26.74. This came on top of a 16 per cent share price decline in the previous four trading days. Fannie Mae’s shares declined by 25 per cent to $28.12 as Freddie Mac’s latest disclosure spooked investors.

Richard Syron, whose contract as Freddie Mac’s chairman and chief executive was renewed two weeks ago, said: “Without doubt, 2007 has been an extremely difficult year for the country’s housing and credit markets.

“It will take time for this market to turn around. But as it improves, we are optimistic about Freddie Mac’s longer-term prospects.”

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