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Tuesday, July 8, 2008

Fannie Freddie and the Mortgage Nightmare

Yesterday brought more bad news for mortgage securitizers Fannie Mae and Freddie Mac.

Shares of mortgage financing giants Fannie Mae and Freddie Mac both plummeted Monday after an analyst with Lehman Brothers wrote in a report that the two companies may need to raise billions of dollars if accounting rules are changed.


According to a report from Lehman Brothers analyst Bruce Harting, the Financial Accounting Standards Board (FASB) is considering a rule change that would force Fannie and Freddie to move so-called off balance sheet securities onto their balance sheets.

The potential accounting change would require Fannie Mae to add $46 billion of capital and Freddie Mac to add $29 billion of capital, Harting noted.


The two companies, which bought securities backed by risky subprime mortgages when the housing market was booming, have watched those bets unravel in the past few months as the housing market buckled under credit crisis pressures.

Fannie Mae has reported a loss for the past two quarters while Freddie Mac has posted three consecutive quarterly losses. Both companies are expected to report a loss in the second quarter as well.

Both Fannie Mae and Freddie Mac, are mortgage insurers that bundle loans together and securitize them as bonds. Both deal with folks that generally have good credit. This is all very important because so far the mortgage crisis has been isolated exclusively in loans for folks with marginal credit. If entities dealing with so called good borrowers begin to experience their crises then this crisis takes on a very troubling new dimension.

There is an ongoing debate among mortgage professionals over just how bad the crisis will be. There are those that see sub prime and so called Alt A loans as the nexus of the crisis. We are the ones that see the crisis as relatively mild. (obviously a very loose term) Then, there are those that see sub prime and Alt A as only the beginning. They see the crisis extending to prime loans.

The continued bad news for these two mortgage securitizers lends more credence to the nightmare scenario. Now, the story says that these two giants bought many of the sub prime loans that have gone bad. I would take issue with that characterization because I don't ever remember either extending their own guidelines to include sub prime borrowers.

Whenever you read about any entity holding onto mortgages that is going through a liquidity crisis, as is happening to both Fannie Mae and Freddie Mac, that is directly as a result of that entity holding onto too many bad loans. Because they are, they can't sell those loans off and thus they have a liquidity crisis.

Of course, according to this story, this liquidity crisis may be due to an accounting rule change, but much of the same principles apply. The plight of both these giants will now become the central issue in the evolving mortgage crisis. Anyone that thought the worst was behind us is fooling themselves.

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