Freddie, Fannie seek a few billion

Freddie Mac and Fannie Mae will have to raise billions of dollars in capital reserves to weather a prolonged credit crisis.

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(Fortune) -- Freddie Mac and Fannie Mae can only make it through a prolonged credit crisis if they raise billions of dollars of new capital.

That, in a nutshell, is what the plunging stock prices of both mortgage buyers are saying Tuesday.

Freddie accounted for a sharply higher batch of bad loans in its third quarter earnings, a little more than a week after Fannie did the same thing. But Freddie said that it would move quickly to raise more capital through a large issue of preferred shares. It added that it was seriously considering cutting its dividend - another capital preserving action. When asked on a conference call if Freddie would have to raise as much as $4 billion by issuing shares, Chief Financial Officer Buddy Piszel declined to quantify the issue's size.

"It will be a large transaction," Piszel said.

Last week, Fannie raised capital in issuing $500 million of preferred shares, but the company will almost certainly have to raise more capital because its bad loan problem is at least as serious as Freddie's.

Freddie (Charts, Fortune 500) stock tanked 29% Tuesday, and Fannie's was down 26%. Both have lost more than half their value since the end of September. The market is worried that that neither company has a strong enough financial footing to deal with further credit losses.

But the Office of Federal Housing Enterprise Oversight, which regulates Fannie (Charts) and Freddie, isn't worried about existing shareholders. It's job is to make sure both companies are strong enough to get through this housing meltdown.

"Freddie Mac's announcement of the steps it intends to take reflects prudential actions for the company that are appropriate in light of current market conditions," said OFHEO director James Lockhart.

Fannie and Freddie are seen to be an important source of demand for mortgages, so any problems at these companies could end up reducing the amount of mortgage lending that gets done by the banks that sell mortgages to Fannie and Freddie. Because of their integral role, it would be no surprise if OFHEO, as well as other financial regulators like the Federal Reserve, were keen to see a ramp up in capital at both companies.

Such capital increases will have to be very large. Neither Fannie nor Freddie is close to having sufficient capital to weather a full-blown recession.

Freddie Mac had $25.8 billion in capital at the end of the third quarter, which is equivalent to just 3.2% of assets. Fannie Mae's $40 billion of capital as of Sept. 30 is equivalent to 4.8% of its assets. Compare that with 8.8% for Bank of America, which has more than $270 billion of residential mortgages on its books.

Why were capital ratios so low for Fannie and Freddie? One reason was that, as government sponsored entities operating under a congressional charter, investors perceived both companies to have an implied government guarantee on their debt. Over time, that lulled investors into becoming comfortable with low capital ratios. In addition, because Fannie and Freddie's mortgages were mostly loans to people with good credit, losses weren't expected to be high on them.

But it has been clear since late 1990s that real and large losses could occur on the financial instruments that both companies use to insure against adverse movements in interest rates. And then Fannie and Freddie started to become exposed to mortgages to people with incomplete or poor credit histories. Losses have started to come in on those.

OFHEO recently penalized Fannie and Freddie for misleading accounting and poor oversight. As part of its measures against the companies, OFHEO has demanded that they hold 30 percent extra regulatory capital. But for Freddie that higher capital number - $34.6 billion - is still equivalent to only 4.4% of assets.

Yup, that capital increase is going to have to be very large indeed.