Fannie and Freddie bounce back
Investors pile into the stocks after the government frees the companies to load up on cheap triple-A mortgage bonds.
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| Shares in both Freddie Mac and Fannie Mae are subject to wide market swings. |
NEW YORK (Fortune) -- The government's efforts to thaw fearful credit markets are lighting a fire under Fannie Mae and Freddie Mac.
Shares in the government-sponsored mortgage companies rose sharply for the second straight day Wednesday. Investors rushed to buy the stock after the firms' regulator, the Office of Federal Housing Enterprise Oversight, eased some capital constraints on Fannie and Freddie in hopes of getting the market for mortgage-backed securities back on its feet. Wednesday's rally - which adds to a sharp run-up tied to Tuesday's Federal Reserve interest-rate cuts - puts the shares up more than 60% from their lows of last week.
After long keeping a tight rein on Fannie and Freddie following accounting scandals earlier this decade, Ofheo has now effectively allowed the firms to plow $200 billion into mortgage securities. Investors fled that market last month amid worries about the toll that falling U.S. house prices and rising mortgage defaults might exact on Fannie and Freddie. Widespread selling of triple-A-rated mortgage bonds, including those backed by Fannie and Freddie, helped lead to the collapse of Carlyle Capital, a heavily leveraged Amsterdam-listed fund that held some $21 billion of the bonds, and the near implosion of jumbo mortgage lender Thornburg Mortgage (TMA).
"This is an effort to prevent further Thornburgs and Carlyles," says Gary Gordon, an analyst at Portales Partners in New York.
The Ofheo decision isn't just good for the bond market. It's good for shareholders in Fannie (FNM) and Freddie (FRE, Fortune 500) because it gives the companies the power to scoop up highly rated mortgage-backed securities that have been trading at a discount. Gordon, who has a buy rating on Fannie and Freddie, says Wednesday's rally shows that investors are starting to appreciate the companies' growth prospects - which are bolstered by improving pricing in both its credit guarantee and mortgage investment businesses - after months of focusing solely on their credit risks.
"There are two issues with Fannie and Freddie," he says: the risk of credit losses, and the reward of strong revenue growth. "The market seems to focus on one or the other, which is why you get these big swings."
The swings in these stocks have been very large indeed. Fannie and Freddie traded in the high $60s last summer, before the full extent of the mortgage meltdown became apparent. Since then they have traded as low as the high teens amid concerns about their exposure to losses tied to the deteriorating U.S. housing market.
Those worries spiked over the past month after both firms reported multibillion-dollar losses for the fourth quarter, and President Bush signed into law a measure giving Fannie and Freddie ability to buy much bigger loans. That move aimed to support slipping house prices in high-cost areas where many mortgages were above Fannie and Freddie limits - but it caused investors to flee the stocks amid worries that bigger loans would mean hefty losses.
But Wednesday's statement from James Lockhart, Ofheo's director, is clearly intended to soothe those fears. Lockhart said Wednesday's decision will allow the companies to bolster the mortgage markets without causing undue strain on their balance sheets.
"Let me be clear - both companies have prudent cushions above the OFHEO-directed capital requirements and have increased their reserves," Lockhart said in a statement. "We believe they can play an even more positive role in providing the stability and liquidity the markets need right now."
Indeed, additional bond purchases by Fannie and Freddie should support prices in the mortgage bond market - which is good for institutions that hold Fannie and Freddie-backed bonds. Higher prices could also help Fannie and Freddie, which must mark-to-market the value of their mortgage portfolios each quarter. Gordon says a sustained rise in mortgage bond prices could allow Fannie and Freddie to reverse some of the hefty writedowns that contributed to their steep fourth-quarter losses.
Gordon also takes heart in Ofheo's stance on the companies' capital needs. "As a key part of this initiative," the Ofheo statement says, "both companies announced that they will begin the process to raise significant capital." Saying you'll begin the process of raising capital is very different from saying you're going to raise capital now, Gordon points out. He believes that if the markets for mortgage securities return to health, Fannie and Freddie may find their balance sheets bolstered by reversals of earlier mark-to-market writedowns.
If that happens, he says, "They just won't need to raise new capital." 
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