Worries grow over big backers of U.S. mortgages
By Charles Duhigg
Tuesday, May 6, 2008
As home prices continue their free fall and banks shy away from lending, Washington officials have increasingly relied on two giant mortgage companies Fannie Mae and Freddie Mac to keep the housing market afloat.But with mortgage defaults and foreclosures rising, Bush administration officials, regulators and lawmakers are nervously asking whether these two companies, would-be saviors of the housing market, will soon need saving themselves. The companies, which say fears that they might falter are baseless, have recently received broad new powers and billions of dollars of investing authority from the U.S. government.
As Wall Street all but abandons the mortgage business, Fannie Mae and Freddie Mac now overwhelmingly dominate it, handling more than 80 percent of all mortgages bought by investors in the first quarter of this year. That is more than double their market share in 2006.
But some financial experts worry that the companies are dangerously close to the edge, especially if home prices go through another steep decline. Their combined cushion of $83 billion the capital that their regulator requires them to hold underpins a colossal $5 trillion in debt and other financial commitments.
The companies, which were created by Congress but are owned by investors, suffered more than $9 billion in mortgage-related losses last year, and analysts expect those losses to grow this year. Fannie Mae is to release its latest financial results on Tuesday and Freddie Mac is to report earnings next week.
Concerns over the companies' finances have prompted a fierce behind-the-scenes battle between nervous government officials and the two companies. Bush administration officials, the Federal Reserve and lawmakers all believe that the companies' financial safety cushion is far too thin and have pleaded with them to raise more capital from investors.
Freddie and Fannie, which are enjoying new growth and profits, have largely resisted those pleas, people briefed on the talks say, because selling new shares could dilute the holdings of existing shareholders and drive down their stock prices. Though executives have promised to raise money this year, they refuse to specify how much and when.
Moreover, the companies are using their new found clout to push Congress and their regulator to roll back the limits that were imposed after recent scandals over accounting and executive pay, according to participants in those conversations.
As a result, high-ranking government officials are now quietly threatening to publicly criticize the two companies if they do not soon raise large amounts of capital, people with firsthand knowledge of those threats say. William Poole, a president of a Federal Reserve bank who has since retired, has warned that companies like Fannie Mae and Freddie Mac are "at the top of my list of sources of potentially serious trouble."
A report released last month by the agency overseeing the companies warned that they pose "significant supervisory concerns" and that Freddie Mac suffers "internal control weaknesses." Lawmakers are pushing to rein in the companies with new legislation. Senator Christopher Dodd, the Connecticut Democrat who leads the Banking Committee, will soon take up legislation giving the government broad authority over the companies. Lawmakers say it is likely a bill will pass this year.
"They are on real thin ice financially," said Senator Richard Shelby of Alabama, the senior Republican on the Banking Committee. "And the way the law is written right now, there is very little we can do to correct that." The companies say such criticisms are without merit. Their latest regulatory filings, they note, show a combined financial safety net that exceeds required minimums by $7 billion. The companies raised $13 billion from investors last year and say any future losses will be offset by new revenue and by money they have already set aside.
"The irony is that right now I'm seeing the best opportunities since I've been in this business," said Daniel Mudd, chief executive of Fannie Mae, in an interview conducted last month. The companies also say that they have not demanded anything. Rather, they say, the limitations have been dropped because of the companies' commitment to financial transparency and aiding the housing recovery.
(J's comment: I have a feeling we will be quoting these soon to be ironic and telling statement in a few quarters when Fannie Mae is struggling just like we did for a certain Bear Stern's CEO on the eve of his company's destruction.)
But others remain concerned. Though the companies' main regulator, James Lockhart III, director of the Office of Federal Housing Enterprise Oversight, has voiced strong confidence in the companies, a high-ranking member of his staff said some officials had begun considering the worst. "It's not irrational to be thinking about a bailout," said that person, who requested anonymity, fearing dismissal.
Fannie and Freddie do not lend directly to home buyers. Rather, they buy mortgages from banks and other lenders, and thereby provide fresh capital for home loans. The companies keep some of the mortgages they buy, hoping to profit from them, and sell the rest to investors with a guarantee to pay off the loan if the borrower defaults.
Because of the widespread perception that the government would intervene if either company failed, they can borrow money at lower interest rates than their competitors. As a result, they have earned enormous profits that have enriched shareholders and managers alike: from 1990 to 2000, each company's stock grew more than 500 percent and top executives were paid tens of millions of dollars.
Those profits were threatened earlier this decade, however, when new competitors emerged and after audits revealed that both companies had manipulated their earnings. The companies were forced to replace top executives, pay hundreds of millions in penalties and consent to strict growth limits.
To keep profits aloft and meet affordable-housing goals set by Congress, the companies began buying huge numbers of subprime and Alt-A mortgages, the highly profitable loans often taken out by low-income and riskier borrowers. By the end of last year, the companies had guaranteed or invested in $717 billion of subprime and Alt-A loans, up from almost none in 2000.
Then the housing bubble burst. In February, the companies revealed a $6 billion combined loss in the fourth quarter of 2007, and both companies' stock prices fell more than 25 percent in two weeks. Despite those troubles, however, lawmakers had few alternatives to asking Fannie and Freddie to buy more and riskier mortgages. "I want these companies to help with affordable housing, to help low-income families get loans and to help clean up this subprime mess," said Representative Barney Frank, a Massachusetts Democrat and the chairman of the House Financial Services Committee. "Otherwise, why should they exist?"
But now that the government depends on Fannie and Freddie to keep markets humming, the companies are making demands of their own namely, repealing some of the limits created after the scandals and even some established by law. Last year, in return for buying billions of dollars of subprime mortgages to help stabilize the market, executives won the right to expand their investment portfolios. In March, the companies agreed to raise more capital within the year. In exchange, they received an additional $200 billion in purchasing power.
Last month, the companies promised to pump money into pricier reaches of the housing market. In return, Congress temporarily raised the cap on the size of the mortgages they can buy to almost $730,000 from $417,000. "We have to bow and scrape and haggle each time we need help," said a senior Republican Senate assistant who spoke only on the condition of anonymity.
Each time Congress or regulators have given the companies new room for growth, their stock prices have risen. But so far the companies have balked at raising more capital. That hesitation has lawmakers concerned that when the companies raise money this year, it will not be enough.
In a March meeting, Freddie Mac's chairman, Richard F. Syron, bolstered those fears by saying the company would put shareholders' interests first. Michael Cosgrove, a spokesman for Freddie Mac, said Syron is committed to both satisfying the company's public mission and creating shareholder value. Fannie Mae, which is in a regulatory-imposed quiet period because it will soon release financial information, declined to comment on capital-raising issues.
(J's comment: Mr. Syron will be "putting the interests of his shareholders first", before his government-backed entity created to help make homes affordable for Americans does anything else. The only thing more troubling than Mr. Syron's comments is the statement made by his "spokesperson" Micheal Cosgrove regarding commitment to their public mission and creating shareholder value. That sounds alot like a financial win-win. The telltale signs of trouble: platitudes by spokesmen. How anyone finds these statements assuring is beyond me and Fannie Mae's inflated share price.)
As worrisome as the need for new capital, some analysts say, are the companies' books. A report released earlier this month by Lockhart, the regulator, noted that although Freddie and Fannie had a combined $19.9 billion of "unrealized losses" on mortgage-related investments, neither company had reduced its earnings to reflect those declines. That is because they judged the losses to be temporary in essence wagering that the mortgage market would recover before those assets were sold. Such a wager is permitted by the rules but difficult for outsiders to analyze.
(J's comment: who decides said losses shouldn't count against the books, and who's crystal ball is being used to surmise that the mortgage crisis will be long gone before they decide to sell any troubled assets?)
Fannie Mae declined to discuss unrealized losses. Cosgrove said Freddie Mac's accounting choices had been the best way to reflect financial realities.
(J's comment: There go the spokespeople: ignoring losses reflect a reality to which only the Fannie Mae brass and their PR folks live in)
Both companies have also recently changed their policies on delinquent loans, which they previously recorded as impaired when borrowers were 120 days late. Now, some overdue loans can go two years before the companies record a loss. Fannie Mae declined to discuss the accounting of impaired loans. A representative of Freddie Mac said marking loans as permanently impaired at 120 days does not reflect that many of them avoid foreclosure.
(J's comment: 120 days... 4 months late on mortgage payments and Freddie Mac declined to comment on how this is not considered impaired? Change accounting rules to benefit your company and send in a representative to decline comment other than to suggest 4 month arrears on a mortgage payment doesn't reflect the reality that most don't foreclose. While we're at it lets consider that most people who have heart attacks don't die right away, why bother sending them to the top of triage at emergency rooms!)
But the biggest risk, analysts say, is that both companies are betting that the housing market will rebound by 2010. If the housing malaise lasts longer, unexpected losses could overwhelm their reserves, starting a chain of events that could result in a federal bailout.
A version of those events began in November, when Freddie Mac's capital fell below Congressionally mandated levels. The company stemmed the decline by selling $6 billion in preferred stock. But it might not manage that again if there is another unexpected loss, analysts say.
"The last two years have shown the real need for a stronger regulator," Lockhart said. If his agency did not curb the companies' growth earlier this decade, he added, "they would be part of the problem right now instead of part of the solution."