Updated from 8:52 a.m. EST

The 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.

The other issue is that if one of these insurers takes a massive hit, then Fannie Mae's underwriting standards may come under scrutiny, and the firm may be forced into buying fewer high-LTV mortgages in the future.

A Fannie Mae representative declined to comment on the issues.

Rival to Subprime Crisis

In November, defaults on privately insured mortgages rose 35%, to a record high of 61,000 nationwide, according to the Mortgage Insurance Companies of America, an industry trade group.

Worries about high-LTV mortgages are now replacing the worries about loans written to borrowers with low FICO scores -- so-called subprime borrowers. That's because falling housing prices across the country are creating situations in which homeowners are facing negative equity in their homes.

For instance, imagine taking out a 95% LTV loan and seeing you're home price fall 20%. You now have a 119% LTV loan.

In a recent research note, CIBC analysts said the "highest losses will be driven by LTVs, not FICO scores."

"Today, as a higher percentage of people own homes and many of them have taken on 'too much house' or high LTV loans, things are different," CIBC analyst Meredith Whitney wrote. "Many previously considered 'prime' customers who took on 80+% LTVs are performing closer to sub-prime loans."

Fannie Mae has $227 billion of exposure to mortgage loans in which the LTV ratios are greater than 90%. Overall, about 19% of the company's $2.4 trillion single-family mortgage book of business has private mortgage insurance or some other form of credit enhancement.

Troubles among bond insurers may provide a clue about how Fannie Mae would be forced to act if mortgage insurers' troubles grow.

Last week, Merrill Lynch ( MER) decided to err on the side of caution by fully writing off $2.6 billion of default protection from bond insurers such as ACA Capital Holdings, because Merrill felt it was worthless. Specifically, $1.9 billion of the insurance came from ACA Capital, a financially distressed firm that is currently controlled by the Maryland Insurance Administration.

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.

Voices of Alarm

So far, Wall Street sell-side analysts have not expressed much concern about the issue for Fannie.

In a November 2007 research note, Lehman Brothers analyst Bruce Harting said Fannie Mae and Freddie Mac were "reasonably well insulated vis-à-vis the mortgage insurance industry in total."

However, some hedge fund managers have been taking a much more bearish stance on Fannie Mae.

One of the biggest public voices of concern has been Nandu Narayanan, chief investment officer of Trident Investment Management, a hedge fund that has been outspoken about shorting housing and credit-related plays. Narayanan previously worked as chief equity strategist with Caxton Associates, one of the world's largest hedge funds.

"It looks to us like a lot of the mortgage issuers will not survive if any kind of really bleak outcome comes to pass," Narayanan told Fannie officials on the firm's last earnings call in November.

"To the extent that some of their risks may not be insurable by them if they're not in existence, it comes back on your books," he said. "So there's clearly a much more complicated interlinked relationship you have with a number of other providers, which are all possibly at risk in this situation."

In response, Fannie Mae's chief risk officer Enrico Dallavecchia said the company believes that the mortgage insurance industry "will manage its capital position to meet the claims obligations that they have."

"I feel comfortable with the exposure that we have to the MI (mortgage insurance industry) at this stage," Dallavecchia said.

While the write-offs of existing mortgage insurance could be looming for Fannie Mae, another worry is that these increased losses will cause Fannie to curtail use of the insurance product in the future.

Fannie Mae continues to use mortgage insurance to buy loans at a maximum LTV of 95% these days, mortgage brokers say.

"What happens if Fannie realizes that mortgage insurance guarantees are worthless and decided not to take mortgage insurance-wrapped mortgages anymore?" says an analyst at a hedge fund that is shorting Fannie Mae and several mortgage insurance firms.

"The whole mortgage world will be turned upside down," the analyst says. "This is the real problem."

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