America's mortgage giants

The cracks are spreading

The supposed saviours of America's mortgage market are its latest victims

WHEN it comes to nasty surprises, this is the credit crisis that keeps on giving. Until recently it had been assumed that Fannie Mae and Freddie Mac, the government-sponsored enterprises (GSEs) that tower over America’s mortgage market, could survive the storm with merely a few bruises. They may own or guarantee almost half of the $11 trillion in outstanding loans but, the thinking went, they would avoid severe pain because they had generally stuck to good-quality credits. Indeed, they even stood to benefit as rival sources of funding dried up.

That script is now being dramatically rewritten. Earlier this month, Fannie posted a $1.4 billion quarterly loss. An even bigger blow came on Tuesday November 20th, when Freddie joined its ugly sister in the red, to the tune of $2 billion, and said that it would seek (read: have) to raise new capital to shore up its balance sheet. Fannie has already tapped markets for more than $500m in fresh equity. Freddie’s share price dropped by 29% on the day of its results, wiping out several years of gains.

Only a few weeks ago, politicians were calling for the lifting of regulatory caps on the portfolios of GSEs—imposed in 2005 after they were found to have mis-stated profits by a combined $11.3 billion—so that they could take up the slack in the mortgage market as private lenders fold or retreat. They have already picked up a lot of extra business and have also been able to raise the fees they charge to guarantee loans. But their capital squeeze—Freddie is down to a mere $600m more than the required minimum—leaves them poorly placed to continue serving as liquidity providers of last resort. As they tighten the spigot to conserve equity, the result will be to exacerbate the housing downturn, says Howard Shapiro of Fox-Pitt, Kelton.

Unlike many banks, Fannie and Freddie are not waist-deep in the most complex and radioactive structured products, collateralised-debt obligations. They stuck to simple loans and relatively straightforward mortgage-backed bonds. But they took on more risk in recent years, including substantial amounts of paper linked to adjustable-rate mortgages (ARMs) for low-income borrowers. ARMs and securities tied to them accounted for almost a fifth of Freddie’s new business in 2006, up from negligible amounts five years earlier.

Actual credit losses are only part of the problem. Freddie set aside $1.2 billion for such hits in the third quarter. Its accountants forced it to mark down other assets by three times that amount to reflect sagging market prices, even though most of them will be held to maturity. Anthony Piszel, the firm’s chief financial officer, says that its numbers are distorted by lots of “uneconomic noise” such as the requirement that Freddie mark its derivatives book to daily market prices, while not being allowed to record offsetting gains in its loan portfolio until much later.

Things would also look less bad if Fannie and Freddie did not have to keep their capital-to-assets ratio 30% above normal requirements. They have been lobbying hard for this “surcharge”—also introduced after their accounting scandals—to be removed. But their regulator, the Office of Federal Housing Enterprise Oversight (OFHEO), first wants to see more progress in improving risk management and internal controls. “This kind of market increases operational risk,” says James Lockhart, OFHEO’s director. Among those who agree with this assessment is the Treasury. It worries about the “systemic risk” posed by the GSEs by virtue of their enormous portfolios, and derivatives markets: the cost of insuring Freddie’s debt against default leapt this week, despite an implicit government guarantee that allows it to borrow at rock-bottom rates.

Mr Piszel told analysts this week that the fourth quarter “will not be pretty”. Nor, in all likelihood, will several after that. Another concern is that the woes ripple out, hurting banks that rely on them to buy or guarantee their mortgages. It was no coincidence that Countrywide, America’s biggest mortgage lender, was forced to deny rumours of imminent bankruptcy on the day that Freddie broke its bad news. If losses continue to eat into the housing giants’ capital cushions, they will not be the only ones left sitting uncomfortably.