Feeling Fannie's and Freddie's pain

Mortgage industry still down

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Cashing in on mortgage meltdown

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• Hiring holds steady
• Half of 'rescued' borrowers still default
• Job outlook gets gloomier
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• Where the jobs are

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NEW YORK (CNNMoney.com) -- The plunging stock prices of mortgage finance giants Fannie Mae and Freddie Mac could make the recovery for the housing market and the overall economy much more difficult, analysts say.

Fannie and Freddie, which were set up by the federal government, play a crucial role in the credit markets. They buy large pools of mortgage loans made by banks and other lenders, attach a guarantee that the loans will be repaid and then sell securities backed by the future payments on those mortgages.

"The housing market can not recover unless Fannie and Freddie are out there actively securitizing home mortgages," said Jaret Seiberg, financial services analyst for research firm Stanford Group.

Shares of the two companies plunged Monday after a note from Lehman Brothers suggested that Fannie and Freddie might be forced to raise a combined $75 billion due to a pending change in accounting rules.

Spokespeople from Fannie (FNM, Fortune 500) and Freddie (FRE, Fortune 500) had no comment about their stock prices or the Lehman report.

Seiberg said the two companies don't need new capital right now to keep buying mortgages. But with both companies expected to report losses this year, they may need more capital down the road.

"They anticipate suffering more losses in the future and capital is one of your cushions against those losses," Seiberg said.

But with shares of Fannie and Freddie each plunging about 60% so far this year, finding investors willing to invest additional capital in the firms will be both problematic and expensive.

If Fannie and Freddie were suddenly unable to buy and back loans, banks would have their primary source of funding for making home loans choked off.

That would severely restrict the pool of potential home buyers, causing home price declines to accelerate from the record drop seen in the last year. That would make it tougher for the economy to rebound anytime soon.

Although Lehman Brothers analyst Bruce Harting downplayed the likelihood that Fannie and Freddie would be forced to raise more capital, the note did spell out the dire implication for housing and the economy should either firm face failure due to rising losses from the more than $4 trillion in mortgages the two firms back.

"We believe any threat of [a Fannie or Freddie] failure could trigger a meltdown in credit markets that would make the movements in credit markets that we've seen over the last year look like a modest hiccup," Harting wrote. "Needless to say, the impact of a dislocation of that order could cause serious harm to the global economy."

With their government charter and their importance to the economy, analysts are convinced the federal government would move rapidly to bailout Fannie and Freddie should they be faced with a failure.

And most analysts believe that this implicit guarantee should stop Fannie and Freddie from facing the kind of crisis of confidence that brought on the rapid demise of Bear Stearns in March.

Jay Brinkman, vice president of research and economics for the Mortgage Bankers Association, says that he believes Fannie and Freddie have adequate capital today, but that it is essential that they be able to continue to raise additional capital going forward.

"Fannie and Freddie do play a crucial role in the markets," he said.
"They're much much larger than anything we saw in the subprime market."

James Lockhart, director of the Office of Federal Housing Enterprise, which regulates the two firms, said in an interview with CNBC Tuesday that he believes the firms have done a good job raising adequate capital.

He said it is important that his agency be given broader oversight over their operation going forward. That need for regulatory reform was echoed Tuesday by Federal Reserve Chairman Ben Bernanke.

"If these firms are strong, well-regulated, well-capitalized, and focused on their mission, they will be better able to serve their function of increasing access to mortgage credit, without posing undue risks to the financial system or the taxpayer," said Bernanke in a speech to bankers..

But others see further risks ahead. The Wall Street Journal's influential "Heard on the Street" column Tuesday wondered whether shares in Fannie and Freddie will have any value left once the housing crisis is done. The column also raised the specter of a government takeover of their operations.

And with trends showing rising defaults in the prime mortgage loans that are the firms' bread and butter, some argue that the worst is yet to come. So the need for a government bailout can not be ruled out.

"These guys are in the business of buying mortgages and the rates of defaults have gone up tremendously," said Barry Ritholtz, CEO and director of equity research for Fusion IQ, an investment fund.

Fusion had taken a large short position on Fannie from November through June, meaning it profited handsomely in the sharp decline in its stock during that period.

"The only thing surprising is that anyone was surprised by the problems," Ritholtz said.