Next To Fall: The Publicly-Traded Government-Sponsored Mortgage Lenders

Includes: FMCC, FNMA
by: Michael Panzner

When the housing bubble burst, the optimists were quick to call for a bottom -- again and again.

Later, when the fallout from that still unfolding meltdown helped trigger a category five hurricane in the subprime mortgage sector, the rose-colored glasses types kept saying the situation would remain "contained."

Then, when the reverberations from that snowballing disaster caused credit spreads to start shooting higher and losses to pile up at a growing number of financial operators, the Pollyannas said it wouldn't affect "liquidity" -- the life blood that has kept the LBO game of musical chairs alive and the stock market floating on nothing but air.

And now, the Mr. Magoos -- and no small number of "smart money" investors who've been piling into the shares -- appear to be saying that all of these various shockwaves are unlikely to have much impact on what many consider to be the poster children of ponzi finance, the publicly-traded government-sponsored mortgage lenders.

Unfortunately, as a recent report from BusinessWeek seems to indicate, "Why Fannie And Freddie Are Fidgety," the delusionists are about to be proved wrong once more.

The financial giants are loaded down with dicey loans as defaults increase

Fannie Mae (FNM) and Freddie Mac (FRE) have been cast as saviors in the housing drama that's roiling the financial markets. After they stepped in to snap up billions of dollars in subprime loans earlier this year, some politicos declared the duo a point of strength: "Freddie and Fannie aren't the problem. [They] are the good part," Representative Barney Frank (D-Mass.) said in a recent hearing.

But that doesn't mean they're immune to the pain. Like the big private- sector players, these government- sponsored companies, which own or guarantee 45% of all residential mortgages, have taken on more risk in recent years. Now they hold a sizable piece of subprime and other potentially toxic debt--securities and largely illiquid loans that could take a hit after the recent fire sale prompted by two Bear Stearns hedge funds. And given the state of the broader housing market, more trouble may lie ahead. That would be bad news for shareholders and investors who own their mortgage-backed securities. "We don't know how much trash is on their balance sheet," says Josh Rosner of researcher Graham Fisher & Co. "It seems they've shot themselves in the foot." Fannie declined to comment. Says a Freddie spokeswoman: "We are well positioned to withstand even a severe and enduring period of heightened credit risk."

Driven by market competition and regulatory mandates, the two have become big buyers of adjustable-rate mortgages, or ARMs, and MBSS that include them. Those items accounted for 18% of Freddie's volume in 2006 and 22% for Fannie in 2005, the latest data available. That's up from virtually nothing in 2001. A large chunk comes in the most exotic flavors, such as payment-option ARMs and interest-only loans.

With home prices falling, ARMs, both prime and subprime, are especially scary. Some $300 billion in ARMs guaranteed by the agencies will automatically reset through 2011, according to Banc of America Securities. The unknown is just how many homeowners will default. By Fannie's own estimates, 18% of the subprime ARMs industrywide that reset in the first three months of 2007 have gone south.

The two have also moved more prominently into low-documentation loans, which require little or no proof of the borrower's income. That segment has proven to be rife with abuse in recent years. A study by the Mortgage Asset Research Institute found that 90% of borrowers with so-called stated income loans upped their annual incomes falsely to qualify for more money. In almost 60% of low-documentation loans, the borrower's income was inflated by more than 50%.

Much of Fannie and Freddie's shift into riskier parts of the mortgage market has been driven by the government's affordable housing mandates, which require the two to fund a lot of loans for low-income borrowers, first-time buyers, and people living in mobile homes or economically distressed neighborhoods. Their regulator, the Office of Federal Housing Enterprise Oversight, estimates that Fannie holds $292 billion of such mortgages, or 40.6% of its portfolio, on its books because the loans are less liquid and can't easily be repackaged and sold to investors. Freddie owns $68 billion of those loans, some 9.5% of its portfolio.

Problems from Fannie's and Freddie's risky loans are mounting. Foreclosures are on the rise, and it's harder to sell the houses they own as a result. Some are worth pennies on the dollar. Fannie has a "charming colonial" on the market for $7,000 in Detroit, despite the $59,000 outstanding on the loan. The property, repossessed in May, has been looted, with the kitchen sink and drainpipes stolen. Meanwhile, agent Debbie Leslie of Le Valley Real Estate has cut the price on a home Freddie owns in Flint, Mich., five times this year, from $10,900 to $5,250. The mortgage is $26,250. "We're waiting to see where the floor is," says Leslie.

Such exposure is taking its toll. Freddie upped its loan-loss reserves by $125 million in the first quarter in response to higher foreclosure rates; the company reported a $211 million loss during that period. Fannie, still reeling from an accounting scandal earlier this decade, hasn't reported its financials for 2006 or 2007, but will likely face a similar fate when it does. Looking at the numbers, says James B. Lockhart III, director of OFHEO, "you can see the impact not only on their portfolios, but also their MBSs."

The tsunami rolls on.