Holes in Freddie's Lifebuoy

Fannie Mae (FNM) and Freddie Mac's (FNM) planned bailout of the subprime lending market is a case of sublime irony.

The so-called government-sponsored enterprises have been under mounting assault for several years, with many on Capitol Hill and on Wall Street calling for a significant scaling back of the agency's combined $1.3 trillion mortgage inventory for fear that a Fannie/Freddie collapse might send the economy into a death spiral.

It's only fitting then that the GSEs should position themselves as potential saviors of a mortgage market under strain from questionable lending practices offered to dicey borrowers.

The Fannie/Freddie bailout could prove a unique and potentially profitable chance for the agencies to regain face, after accounting scandals damaged the reputation of both. But the move also provides an opportunity for them to try and claw back mortgage business that Street firms had taken since scandals forced Fannie and Freddie into the penalty box.

Fannie and Freddie, given their implied government backing, have operated with great privilege. Franklin Delano Roosevelt signed off on the creation of Fannie in 1938 in order to foster liquidity in the mortgage market and homeownership and Freddie was borne out of The Emergency Home Finance Act of 1970.

Together the mortgage duo buys mortgages that comply to certain credit and size criteria from banks and other lenders to keep on their books or repackage and sell them to other investors. With the assumption that the government would bail them out in the event of a crisis, in the past they have benefited from the difference between their low borrowing costs and the prices they can sell assets.

But Fannie and Freddie have been losing traction in the mortgage market since the start of the housing boom, notes Brian Harris, senior vice president at Moody's Investors Service(MCO).

"No doubt the marketplace has become increasingly more competitive," says Doug Duvall, Freddie spokesman in McLean, Va.

Historically, the agencies have only invested in subprime via the high-quality triple-A slices of securities backed by residential mortgages. Their move now marks a slight departure in going down the credit ladder.

"Part of our mission is to provide liquidity down the credit spectrum but we're hoping to do it in a way that makes the market more stable and transparent," Duvall notes, declining to say how low down in credit quality the agency might go.

"We're taking a risk here and trying to lead a market that might not follow," Duvall comments.

Explaining why the agency had not participated in subprime earlier, Fannie spokesman Alfred King says, "We did not think the pricing reflected the risk."

Duvall says Freddie is developing improved fixed-rate and adjustable-rate mortgage products and trying to create other products, that the company has not yet hashed out, to offer subprime borrowers. "We're hoping to set new standards and offer alternatives," he says, adding that it intends, at least early on, to purchase subprime whole loans because it will have greater control in servicing them and hold them in its portfolio.

Some of the offerings that the agencies are talking about include 40-year loans, reduced adjustable-rate margins, with longer, more manageable initial rates and longer reset periods to limit "payment shock."

"Unfortunately, Fannie Mae-quality, safe loans in the subprime market did not become the standard, and the lending market moved away from us, said Fannie CEO Daniel Mudd in his testimony to the to the U.S. House of Representative Committee on Financial Services. "Borrowers were offered a range of loans that layered teaser rates, interest-only, negative amortization and payment options and low-documentation requirements on top of floating-rate loans," he added.

Establishing products and underwriting criteria that work for borrowers -- while also passing muster with the investors that buy these loans -- will be the challenge for both agencies.

"We want to change our existing products to make them more appealing to subprime buyers in the secondary market, remarks Duvall. "That's the catch," he adds.

Jim Vogel, executive vice president at FTN Financial Capital Markets, notes that even if the new loans prove popular, there's no guarantee that banks will want to sell them to Fannie or Freddie because it may be more profitable to hold on to them or securitize them in-house.

"In the end, the large lenders may prefer to fund the cream of the crop themselves and get the income, rather than sell it to Fannie or Freddie," Vogel adds.

Competition to provide subprime mortgages has thinned out some with players exiting the business and lenders such as New Century going bankrupt but it will continue to be the focus of firms such as J.P. Morgan(JPM), Merrill Lynch(MER), Washington Mutual (WM) as well as other financial institutions who have the wherewithal to offer loans cheaply and securitize them.

With all the underwriting tighten that's taking place it's also unclear how what the subprime market might look like going forward.

Meanwhile, the agencies themselves continue to be under tremendous scrutiny and it remains to be seen how much goodwill, if any, their subprime bailout program has afforded them as Congress continues to review legislation requiring more stringent oversight of the GSEs.

Since the accounting scandals, the Office of Federal Housing Enterprise Oversight and the Securities and Exchange Commission have required that both to strengthen their accounting systems and corporate governance.

"OFHEO has had discussions with Fannie Mae and Freddie Mac on their plans. Conceptually, refinancing subprime borrowers into safer mortgages is a good approach. We will continue discussions to ensure the programs are implemented in a safe and sound manner," says OFHEO Director James Lockhart in an emailed statement to TheStreet.com.

It's all teed up for them, says Tom Mitchell equity analyst at Miller Tabak, who covers Freddie.

Now if only the agencies can get back on a timely financial reporting schedule.

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