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Regulator Lifts Caps on Fannie, Freddie

Nat Worden

A federal regulator on Wednesday lifted restrictions on Fannie Mae(FNM Quote) and Freddie Mac(FRM Quote) amid signs the government-sponsored housing giants had rectified accounting concerns that emerged earlier this decade.

The two stocks -- along with the wider market -- received an initial boost from the Office of Federal Housing Oversight, which said it would lift portfolio growth caps on retained mortgages portfolios. The rally came despite Fannie's report earlier in the day of huge losses due to a downturn in the U.S. housing market that threatens to plunge the economy into recession.

Fannie swung to a fourth-quarter loss of $3.56 billion on spiking credit-related costs, including a steep increase in money set aside for loan losses. It lost $3.80 a share, compared with a profit of $604 million, or 45 cents a share in the year-ago period. Analysts polled by Thomson Financial had expected a loss of $1.24 a share.

For the full year, Fannie lost $2.1 billion, or $2.63 a share, compared with a profit of $4.1 billion, or $3.65 a share, in 2006. Analysts had expected a loss of 5 cents a share.

Howard Shapiro, analyst with Fox-Pitt Cochran Caronia, says he expects Freddie Mac's results to be even worse. Freddie is set to report Thursday morning.

Shares of Fannie closed up 30 cents, or 1.1%, to $27.27. Freddie's stock ended the day down 12 cents, or 0.5%, to $25.09.

"Today's filing closes a period of rebuilding at Fannie Mae, both to re-do our accounting and internal controls, and to strengthen the enterprise for the future," said Fannie President and CEO Daniel Mudd. "At the same time, Fannie Mae's management and employees are fully focused on meeting the challenges of a troubled housing and mortgage market -- and pursuing the long-term opportunities that our business and our mission present to us."

Graham Fisher & Co. analyst Josh Rosner says the end of the portfolio caps, which will go into effect this weekend, is more about generating positive headlines for both companies than it is for helping their performance or the struggling housing market in general. He noted that the required 30% capital cushion above the statutory minimum capital requirements at Fannie and Freddie will remain in place for the foreseeable future.

"Those requirements are in place because of the internal control weaknesses at both companies," says Rosner. "You can raise the portfolio cap, but the heavy capital requirements will for the most part make it more profitable for these companies to focus on the guarantee business rather than their portfolio business."

Fannie and Freddie, created to help expand homeownership and to provide market stability, account for 45% of the $11.5 trillion residential mortgage market. They make money by holding mortgage assets and by guaranteeing securities they create out of loans from lenders.

Fannie showed strong growth in guarantee fees in the fourth quarter, as well as improved expense management. Executives on the conference call also said they expect a pick-up in mortgage refinancings in 2008 as the Federal Reserve lowers interest rates, but right now, mortgage rates are rising despite the Fed's actions. Meanwhile, the positive trends were overwhelmed by massive credit losses that are expected to continue in 2008 and potentially get much worse.

The biggest factors driving Fannie's declines in the fourth quarter were a $3.2 billion loss to the value of derivatives used to hedge its net assets and a $2 billion increase to reserves for credit-related losses. For the full year, Fannie's credit-related expenses, including higher loan loss provisions, increased to $5.01 billion from $783 million in 2006.

Fannie raised its estimate for a national decline in home prices in 2008 to a 5% to 7% drop. Previously, it had expected a 4% to 5% decline. It also forecasts a total peak-to-trough decline of 13% to 17%, up from its earlier view of 10% to 12%.

Moreover, Fannie sees its credit loss ratio, used to judge the credit quality of its existing guaranty book of business, increasing 11 to 15 basis points, up from its earlier view of 8 to 10 basis points.

"We are working through the toughest housing and mortgage markets in a generation," Mudd said. "Our results for 2007 reflect the challenging conditions in the market we serve. While we are pleased that demand for our mortgage guaranty businesses has surged as we respond to the market's urgent need for liquidity and stability, this positive trend has been far outweighed by the negative financial impacts of rising mortgage defaults, falling home prices, and extraordinary disruptions in the credit markets."

CFO Stephen Swad noted an extremely illiquid credit market led to a majority of 2007's losses in the form of mark-to-market valuation declines. The company's five-year swap rate, used to shield the fair value of its net assets against fluctuations in short- and long-term interest rates, declined by 131 basis points in the fourth quarter

To bolster Fannie's capital position, Swad pointed to the $7.8 billion the company raised in a preferred stock sale in the fourth quarter.

"We will continue to evaluate further avenues to conserve our capital and reduce the impact of market disruptions on our capital base," Swad said.

About half of the $5.01 billion in full-year credit-related losses were due to an increase in loan loss provisions to backstop bad loans charged off in some of the country's worst housing markets. Fair value losses to loans purchased from mortgage-backed securities spiked to $1.4 billion in 2007 from $204 million in 2006. Fannie often buys the delinquent loans in an effort to prevent foreclosures.

"Right now, everyone is focused on the severity of credit losses on the private label, but the biggest risk is that people don't fully appreciate that Fannie and Freddie's core business on the guarantee side is susceptible to significant deterioration in conforming conventional credit quality," says Rosner.