Some of the Reasons Freddie Mac and Fannie Mae Have Problems

The excerpts below from an article in the WSJ gives a good summary of the some the problems the face Freddie Mac and to some extent Fannie Mae. It appears that most of their problems originate from “non-agency” securities. The real concern here is that Fannie of and Freddie are the backbone of the “agency” portion of the mortgage business and problems with them will cascade (not ripple) through the mortgage lending business. There are really two issues. For Example, what happens to Countrywide if Fannie and Freddie cannot buy their “agency” mortgages. Or what happens to the mortgage business in more stable banks cannot sell their mortgages to Fannie and Freddie. Text in bold is my emphasis.

Freddie Mac earlier this week reported a $2.03 billion loss for the third quarter and jacked up its provisions for loan losses. But that doesn't mean all the potential bad news is out.

Questions remain about the value of the U.S. government-sponsored mortgage company's securities backed by subprime mortgage loans. These are "nonagency" securities, issued by Wall Street firms rather than Freddie or its main rival, Fannie Mae. Freddie says it has $105.4 billion of these bonds, accounting for about 15% of its holdings of mortgages and related securities.

Freddie and, to a lesser extent, Fannie bought subprime mortgage bonds in recent years to take advantage of relatively high yields and to meet federal rules requiring the companies to devote increasing portions of their mortgage financing to low-income borrowers.

Whether Freddie eventually is forced to write them down matters because the company is short of capital. The third-quarter loss left its capital at just $600 million above the minimum required by its regulator, the Office of Federal Housing Enterprise Oversight, or Ofheo. That has forced Freddie to make plans to raise about $5 billion through a sale of preferred stock, likely to be launched early next week.

Moshe Orenbuch and Kerry Hueston, analysts at Credit Suisse Group in New York, warn that Freddie may need to write down the value of the subprime bonds by as much as $5 billion next year. Investors are so wary of such bonds that there is very little trading in them, making it hard to pin down the market value. But the analysts say the ABX indexes, a widely followed gauge of the value of subprime mortgage bonds, suggest the market value is between 75 and 90 cents on the dollar.

In an interview, Freddie's chief financial officer, Anthony "Buddy" Piszel, argued against the need for a write-down. Nearly all of the subprime-mortgage bonds held by Freddie are rated AAA, and holders of the lower-rated bonds absorb the first losses from defaults. More than half of the mortgage borrowers whose loans are included in the bonds would have to default before Freddie would have losses, Mr. Piszel said.

He said most of the subprime bonds held by Freddie have a market value above 90 cents on the dollar, based on value-estimate services the company uses. The ultimate value of the bonds won't be known for years. It depends on how many homeowners default and how much can be recovered by selling their homes.

Fannie Mae held about $42.4 billion of similar securities as of Sept. 30, accounting for about 6% of its mortgage holdings. Mr. Hueston of Credit Suisse says Fannie also may need write-downs, but he hasn't estimated the potential damage. Fannie has said it doesn't expect losses on these mostly AAA subprime bonds and that the ABX index isn't a good measure of their value.

Both companies say they don't own subprime collateralized mortgage obligations, or CDOs, a more complex type of security that led to huge write-downs at some Wall Street firms.

Mr. Hueston says Freddie's auditors or Ofheo eventually are likely to insist on a write-down if the bonds continue to trade far below their face value. In a statement, Ofheo Director James Lockhart said that "at this point it does not surprise me" that Freddie hasn't written down the subprime bonds. He said the company is following generally accepted accounting principles. "We will be monitoring this on an ongoing basis," he added.

The Credit Suisse analysts forecast that Freddie will report an overall loss of $2.4 billion for the current quarter and $1.1 billion for 2008 as a whole. That doesn't include a possible write-down of the subprime securities, which would make the loss bigger.

In buying these bonds, Fannie and Freddie helped fuel the increase in subprime loans, many of which are now moving into foreclosure, says Judith Kennedy, chief executive of the National Association of Affordable Housing Lenders, which represents banks and nonprofits that make loans in low-income areas. She argues that Fannie and Freddie could have found better ways to finance affordable housing.

Executives at Fannie and Freddie say they had to buy the securities to meet the federal rules requiring them to devote an increasing proportion of their resources to financing homes for low-income borrowers. If they hadn't bought these bonds, the two companies say, other investors would have.