No room in the lifeboat

What if, at precisely the time they are needed the most, Fannie Mae and Freddie Mac are forced to cut back on their mortgage loan purchases, guarantees, and securitizations?

That's the specter raised by recent earnings reports by the government-chartered mortgage giants. Freddie Mac said today that not only did it lose $1.2 billion in the third quarter, but it bounced up against capital requirements imposed by federal regulators, forcing it to sell $45 billion in loans in September and October (see Inman News story).

Freddie Mac estimated its core capital at the end of the quarter was $34.6 billion -- a mere $600 million above the 30 percent capital surplus requirement set by the Office of Federal Housing Enterprise Oversight (OFHEO).

If it can't raise more capital -- one move being considered is to cut shareholder dividends by 50 percent -- then Freddie executives say they may have to to limit growth or reduce the size of the company's retained loan portfolio, and slow down the pace at which it guarantees loans.

Fannie Mae, which on Nov. 9 reported $1.4 billion in third-quarter losses, has a little more leeway -- it's core capital at the end of the third quarter was $41.7 billion, or $2.3 billion above OFHEO's requirements.

According to OFHEO, at the end of the third quarter of 2007, Fannie and Freddie guaranteed $3.2 trillion in mortgage-backed securities held by others, and held $1.4 trillion in their retained mortgage portfolios. (About 58 percent of Fannie Mae’s retained mortgage portfolio, and 90 percent of Freddie Mac’s, are mortgage-backed securities rather than indivual loans). 

The government-sponsored entities (GSEs) combined market share of residential mortgage debt outstanding was 40 percent at the end of the second quarter. Together, Fannie and Freddie buy, sell and securitize more than $100 billion of mortgages per month.

This chart, from an OFHEO report, shows the GSEs more than quadrupling their "book of business" in the last two decades, to $4.7 trillion (note the steep growth from 2000 to 2003, before accounting and management scandals put the brakes on growth in the retained portfolios).

But some lawmakers were hoping Fannie and Freddie could expand their purchase and guarantee activities to provide even more liquidity to secondary mortgage markets. Lenders like Countrywide Financial Corp. have been forced to shift much or all of their loan production into loans that are eligible for repurchase or guarantee by the GSEs, as Wall Street investors have gotten cold feet about loans that don't meet Fannie and Freddie's criteria.

The flow chart shown here, also from OFHEO, shows the critical role Fannie and Freddie play in providing liquidity to lenders. The crude red arrow is my addition to the flow chart, showing how, during the housing boom, Wall Street bypassed Fannie and Freddie to provide funds to lenders.

(Click any chart to enlarge)

Legislation has been introduced that would let the GSEs not only purchase more loans, but raise the $417,000 conforming loan limit so Fannie and Freddie could move into what's now considered jumbo loan territory. Under current regulations, Fannie and Freddie's retained loan portfolios are capped at $735 billion each, with 2 percent annual growth. 

The latest news from the GSEs looks like a setback to those who seek to expand their operations, because they seem to support the Bush administration's position that Fannie and Freddie pose "systemic risk" to financial markets and that caution should be exercised in expanding their activities (The news has taken a toll on the companies' stock prices, with both falling around 25 percent today).

But there are still some who will argue that the only reason Freddie is bumping up against OFHEO's 30 percent capital requirement is that it is excessive. The 30 percent requirement, implemented in the wake of management and accounting requirements, is far stricter than the statutory limit (see OFHEO chart). OFHEO maintains the statutory limit is inadequate, because it would allow the GSEs to keep capital levels at about half the level large banks must maintain to be classified as "well capitalized."

The GSEs say their exposure to the subprime debacle is limited. According to OFHEO, as of June 30 Fannie and Freddie held $170 billion in AAA-rated private-label mortgage-backed securities (MBS) backed by subprime mortgages. That's a fairly small slice of the $1.2 trillion subprime market, but the GSEs have committed to purchase $40 billion in refinanced "rescue" loans made to current subprime borrowers in the next few years.

OFHEO says that it's encouraging such purchases, because they will be made under federal guidelines for nontraditional and subprime loans. "OFHEO has been monitoring the Enterprises closely to ensure that they make and manage these purchases in a safe and sound manner," the office said in a report this month.

So the bottom line from regulators, as far as the GSEs' exposure to turmoil in mortgage markets, has been: "So far, so good -- but don't expect us to go along with Fannie and Freddie biting off an even bigger share."

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