Fannie Mae's

(FNM)

and

Freddie Mac's

(FRE)

first-quarter results do not bode well for a quick recovery in housing or bank balance sheets dependent on it.

When Fannie and Freddie were placed in federal conservatorship last September, their stocks fell off the radar screens of many investors as they plummeted to subterranean levels. But the companies remain twin 800-pound gorillas in the room of mortgage finance, because they hold or guarantee more than half of the country's housing assets and may still prove useful gauges for bank valuations, forecasts and risk.

Accounting rule changes have allowed companies to shift the process for assigning a value on sparsely traded assets from marking them to market prices to marking them to what financial models say they should be worth. Fannie acknowledged as much in its first-quarter report, saying that the process of valuing assets has become "more complex" and "involves a greater degree of management judgment" as the housing and credit markets have come under increasing strain.

But however Fannie and Freddie decide to value their assets influences the market, simply because of the size and scale of the companies. Their interest rates are a benchmark for the mortgage market; their moves to halt foreclosures and adjust mortgages for troubled borrowers were followed by major banks. Similarly, investors can bet that the way Fannie and Freddie value mortgage-backed securities will be reflected on other companies' books -- and may offer clues on how to value bank stocks.

Christie Sciacca, director at the consulting group LECG, notes that while Fannie and Freddie have been suffering huge losses, their assets aren't as troubled as the private-label securities held on many banks' balance sheets. Those MBS are more distressed, riskier, and thinly traded because they don't come with government backing.

"Any bank that has a mortgage banking platform had a boost in the first quarter because of refinancing, low interest rates and other incentives," says Sciacca, a veteran of the Federal Deposit Insurance Corp. and Federal Housing Finance Board. "But residential mortgage-backed securities that are private label aren't out of the woods yet, so to speak."

While there has been much talk of "green shoots" in the housing market, most of that relates to conditions that are getting less worse, rather than better. Fannie and Freddie lost over $33 billion during the first three months of the year, and asked the government for another $25 billion to plug holes in their balance sheets. Those losses were caused largely by over $50 billion in credit expenses and securities losses.

Freddie's interim CEO, John Koskinen, acknowledged "preliminary signs" of slowing price declines, and hope that potential buyers will be wooed by low rates and cheap homes. Still, he was blunt about the reality of an impending rebound: "We expect the coming quarters to be difficult," Koskinen said in a statement.

Fannie didn't provide direct comments from CEO Michael Williams, but emphasized that "persistent deterioration" in the housing and financial markets has continued to hurt performance.

"Our entire guaranty book of business, including loans with lower risk characteristics, has begun to experience increases in delinquency and default rates," Fannie said.

Looking ahead, the two firms set aside over $64 billion in reserves for additional credit losses in upcoming quarters. The outlook is based on three main factors: home prices, credit quality, and frozen securities markets.

Prices are still declining, but at a slower rate. Fannie expects home prices to fall anywhere from 7% to 12% further this year vs. last year's 10% decline, and a drop of 3.7% in 2007. Using the S&P/Case Shiller Index method, which has some differences in asset mix, prices are predicted to drop a more severe 12% to 18%.

At the same time, asset quality continues to deteriorate. Loss, delinquency and default rates have eased on loans that were made earlier this decade, but remain high. Mortgages issued in 2006 are still highly troubled and problems with 2007 and 2008 loans are beginning to ramp up.

Losses from the most severely troubled assets -- loans given to borrowers who were subprime, intended to pay interest-only, put little cash down, had low-credit-scores or little documentation -- may have peaked, but remain highly problematic. The worst loss rates on troubled MBS portfolios remain near 40%, and, as has been the case throughout the crisis, assets that stem from California, Florida, Arizona and Nevada are struggling the most.

The spread of unemployment has begun to stretch troubles into ever more credit-worthy loans. It has also weakened consumer confidence for credit-worthy borrowers who might have otherwise taken advantage of low interest rates and cheap prices.

Earnings reports from the country's biggest banks --

Bank of America

(BAC) - Get Report

,

Citigroup

(C) - Get Report

,

JPMorgan Chase

(JPM) - Get Report

and

Wells Fargo

(WFC) - Get Report

-- struck a similar tone to Fannie and Freddie on the state of distressed mortgage assets. However, much of the troubling signs seemed to be lost on investors because of the booming bottom-line results.

Banks strived to emphasize the benefits from the refinancing boom, better interest margins and improving capital markets. They also played down the risk of bad assets, which they assured investors had been written down amply. However, it's worth noting that the underlying issues still exist on problem loans that are hard to value and harder to sell.

Government initiatives like the Term Asset-Backed Securities Loan Facility and the Public-Private Investment Program have potential to improve the market for those securities, but it's generous to say that those programs have gotten off to a slow start. That's mostly because bidders and sellers have maintained a wide differential on the price.

"I'm skeptical of all of these programs," says John Douglas, former general counsel of the Federal Deposit Insurance Corp. and current chair of the banking and financial institutions practice at Paul Hastings law firm. The firm is telling both hedge fund and bank clients to monitor developments in TALF and PPIP, but not to rely on them for a solution.

With home values expected to fall further, unemployment expected to continue to rise and consumer confidence in the gutter, it's unlikely that even the most optimistic modeling will predict gains any time soon. Even if government programs ultimately help boost market prices, troubled mortgage debt is unlikely to move from 25 cents on the dollar to 90 cents. Even doubling prices on some securities is a massively losing proposition for the seller.

Another issue with bank balance sheets was made clear when the PPIP program was unveiled in March. As Rochdale Securities analyst Richard Bove noted at the time, it has "great potential to eliminate the securities problems at financial institutions," but "it offers little to solve the loan problems."

Sciacca says that, as an investor, he would want to know exactly what the bank holds in private-label MBS, and how the market risk and economic risk affect the outlook. He also notes that banks hold not only mortgage securities, but whole loans whose future is unclear.

"The fact of the matter is, there is still risk in those securities," he says. "The market hasn't come back yet for a reason ... and I think the bigger issue is going to be not the mortgage-backed securities but the whole loans -- what are you going to do with the whole loans?"

While the federal "Making Home Affordable" program, which sought to put a floor under the housing market, has clearly helped banks earn more from a surge in refinancing, Fannie said "the program will likely have a material adverse effect on our business, results of operations and financial condition." That's because the program seeks to help borrowers by having companies and the government book losses instead, and expand credit at what some would characterize as artificially low rates.

The situation seems to represent yet another Catch-22 of the financial crisis: What helps the borrower doesn't always help the lender, yet both must improve for the crisis to recede.