Updated from 8:52 a.m. ESTThe private mortgage insurance industry is under severe pressure from rising delinquencies and mounting losses. Now questions are swirling about how a potential blow-up in that sector will affect Fannie Mae ( FNM). As the largest purchaser of U.S. mortgages, Fannie Mae provides an essential backstop to the housing market. The government-sponsored entity, like its brother Freddie Mac ( FRE), purchases mostly standard 80% loan-to-value mortgages -- those for which the homebuyer puts down 20% equity. Due to a quirk in its charter, Fannie Mae is allowed to purchase mortgages with loan-to-value, or LTV, ratios greater than 80% -- and as high as 100%. Generally, these are allowed only if the homeowner purchases mortgage insurance to cover the amount of the loan above 80%. This business model works fine as long as Fannie Mae believes it can be reimbursed from the private mortgage insurers. But as housing prices fall, borrowers are defaulting at a faster pace on high-LTV mortgages. In turn, private mortgage insurers -- who cover these risky loans -- have had their stocks crushed. Shares of the three leading private mortgage insurers -- PMI Group ( PMI), MGIC Investment ( MTG) and Radian Group ( RDN) -- have tumbled 30% to 70% over the past three months as investors worry about whether the companies can fund their payments to lenders as mortgage defaults rise. There are a few looming questions regarding Fannie Mae's exposure to the private mortgage insurers. One is whether Fannie Mae has adequately reserved for possible losses, because the company operates with the understanding that the insurers will pay it back.
In its most recent quarterly filing, Fannie Mae said it had $130.3 billion of recoveries from private mortgage insurance policies and other credit enhancements. However, if the firm decides that portions of its mortgage insurance are useless, then increased default reserves -- and thus larger writedowns -- may be looming. Fannie Mae has just $39.9 billion of shareholder equity to absorb these losses. The mortgage insurers, meanwhile, are warning of big hits. Late Tuesday, MGIC said it expects losses of $1.3 billion in the fourth quarter. The insurer also raised its paid loss forecast for 2008 to a range of $1.8 billion to $2 billion, worse than its previous estimate of $1.2 billion to $1.5 billion. The company warned that cure rates have continued to deteriorate, resulting in a higher percentage of delinquent loans that become paid claims. Shares of MGIC were plunging 28% to $11.60 Wednesday.