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TheStreet Open House

The Shared Hidden Risk of Fannie Mae

Editor's Note: This article was originally published on RealMoney.com in October of 2002.

In my last article I wrote a little about the Fannie Mae situation and the risks potentially growing there. I say potentially because we don't all agree on the matter. I got a nice email from the people at Fannie Mae, stating their side of the story, which I will share later in the column.

Fannie Mae is a government-sponsored enterprise, and that status provides the company with certain privileges. Fannie is exempt from Securities and Exchange Commission requirements, as well as state and local taxes, saving the company billions of dollars annually.

Additionally, the company can borrow at lower interest rates than conventional banks, and it also enjoys a $2.25 billion line of credit from the Treasury Department in case of economic difficulty.

Furthermore, the Federal Reserve has the legal authority to purchase the debt of housing-related government-sponsored enterprises such as Fannie Mae. So if anything goes wrong, we, the taxpayers, will be the ones to bail them out. They keep their profits, but we share their risk.

These safety nets have made Fannie Mae very attractive to investors. As our equities markets have crashed, investors have poured money into bond funds, especially those holding government-backed mortgage securities.

This year, more than $16 billion has moved into mortgage-backed funds according to AMG Data Services, which tracks mutual-fund flows. Mortgage-backed bond funds have gained an average of 6% for the year, and over the past five years they've outperformed Treasury bond funds.

But there are some risks looming that we as investors, and taxpayers, should be aware of.

Rate-Cut Risks

The Fed's last meeting seemed to leave the door open for a future rate cut. Two members even voted against leaving rates unchanged this time. If rates are again lowered, this spells trouble for Fannie Mae. With that in mind, Merrill Lynch downgraded Fannie's stock last week.

If you listened to Timothy Howard, Fannie Mae's chief financial officer, at the Banc of America Securities Conference last week, you heard him talk a lot about matching the initial durations of mortgages and debt. What this means is that Fannie won't pay for a 30-year loan with money received from issuing 10-year bonds. The "duration gap" would be too much. The bigger the gap, the higher the risk.

Should homeowners refinance with lower rates, they will be paying off their old higher-rate mortgages before the matching bonds are due, throwing everything off plan. Any new mortgages then issued will be at lower rates, and may not cover the interest due on the bonds. This obviously takes a bite out of profits. (Earlier Tuesday, Fannie said the duration gap between its assets and liabilities narrowed to 10 months in September from 14 months in August.)

Concern seems to be growing in Washington about taxpayer risk from these government-sponsored enterprises. Last year Fannie issued $918 billion in mortgage-backed securities and $485 billion in unsecured debt. Fannie Mae and Freddie Mac, which account for nearly three-quarters of all housing loans, have gotten so big that their failure would endanger our entire system.

Rep. Richard Baker (R., La.), chairman of the House Subcommittee on Government Sponsored Enterprises and Capital Markets, has been working on tighter controls. Legislation was passed 10 years ago to regulate Fannie Mae and Freddie Mac, but we are only now seeing the first action.

According to published reports, Baker is gathering increasing support from his House colleagues. Rep. Ron Paul (R., Texas) in July proposed the Free Housing Market Enhancement Act, which would repeal special privileges for housing-related government-sponsored enterprises. If these legislators make any more headway, this will have serious implications for investors.

In It Together

Delinquencies are increasing, and foreclosures have climbed to all-time highs. As I stated before, the Mortgage Banker's Association of America reported that home foreclosures recently reached a 30-year high of 1.23% of all loans in the second quarter. The increase is being attributed to changes in lending, including more frequent use of interest-only, low-down-payment loans, and rising unemployment.

According to Fannie Mae's Howard, last year the loans the company owned or guaranteed "experienced total credit-related losses of around half a billion dollars. But less than a fifth of these losses appeared on Fannie Mae's income statement. The rest were absorbed by our risk-sharing partners -- mortgage insurers, the government as insurer of Federal Housing Administration or Department of Veterans Affairs loans, or lenders to whom we have recourse in default."

In short, someone is going to pay for those defaults, it just isn't going to be Fannie Mae. And in the case of the government as insurer of FHA or VA loans, hey, that gets passed on to us.

In the email I received from Fannie Mae, company officials said the "trend on our foreclosure numbers is opposite of that contained in MBA's National Delinquency Survey."

The email also stated that "as a fundamental business practice, Fannie Mae implements a broad range of risk-mitigation strategies, monitors credit risk trends and routinely explores risk management opportunities, such as transferring risk to third parties and mortgage insurance, to minimize credit risk. Moreover, in the event mortgages become at risk to default, Fannie Mae employs strategies to reduce loss exposure through resolutions other than foreclosure. These techniques leave Fannie Mae with little to no risk that mortgages in default will affect our ability to repay debt investors."

I appreciate their response, and I hope they're right and that they continue to defy the gravity of the general economic trends. I can't help but be concerned that if employment doesn't pick up soon, more people won't be able to make their payments. That isn't just a risk to investors; that's a risk to us all.

Ken Wolff is founder and chief executive officer of Paradise, Calif.-based InvestingOnMomentum.com, a daytrading and swingtrading Web site. This column provides general information about momentum trading. TheStreet.com has no affiliation with InvestingOnMomentum.com, and no endorsement of InvestingOnMomentum.com or momentum trading is intended. At the time of publication, Wolff had no positions in any of the securities mentioned in this column, but positions may change at any time. While Wolff cannot provide investment advice or recommendations here, he invites you to send your feedback to Ken Wolff.

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