February 28 2008: 12:55 PM EST
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Fannie and Freddie smile through crisis

Even as the private sector flees the mortgage market, the two money-losing government-backed lenders will take on more risky debt.

By Colin Barr, senior writer

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Fannie Mae and Freddie Mac are being allowed to take on yet more risky housing-related debt.

(Fortune) -- The housing bust is handing Fannie Mae and Freddie Mac a fresh chance to rebuild their battered images. But the hefty losses the firms reported this week, and worries about the health of the economy, show it won't be easy.

The Office of Federal Housing Enterprise Oversight, which regulates Fannie and Freddie, said Wednesday it would lift portfolio-growth restrictions that have fettered the companies for the past two years. Lifting the portfolio caps could free Fannie and Freddie to substantially expand their holdings of mortgages and related securities, beyond the $746 billion which each firm is presently allowed to hold. OFHEO said the move rewards the companies for tightening up the lax management policies that led to multibillion-dollar financial restatements and executive shakeups earlier this decade.

But the decision - welcomed by both Fannie and Freddie - also hands policymakers another weapon as they seek to ease the pain of the housing bust, which has left many homeowners in distress. After all, many private investors are fleeing the mortgage market, suggesting that Fannie and Freddie may be stepping into treacherous territory.

Another lender delivered a reminder Thursday of just how sour the mortgage markets have turned. Thornburg Mortgage (TMA), which specializes in jumbo loans - mortgages bigger than the ones Fannie and Freddie invest in - said values in the mortgage securities market have dropped so sharply this month that the company might have to sell assets to meet margin calls, even though it doesn't expect to recognize losses on the bonds themselves.

The decision to lift the portfolio caps is a natural one, says Jeffrey Miller, CEO at investment adviser NewArc Investments in Naperville, Ill., because it gives officials an easy way to offer a bit of support to housing prices and ease worries about the health of the economy. "Any solution will have to go through the GSEs," says Miller, referring to Fannie and Freddie as governmet-sponsored enterprises. He notes that the move to expand the mortgage caps shows how policymakers naturally "look to structures that already exist to deal with problems."

Some legislators want to go further. Sen. Charles Schumer urged OFHEO to eliminate a requirement stemming from the GSEs' mid-decade accounting problems that Fannie and Freddie hold additional capital to protect against future losses. "OFHEO should announce a plan to lift that surcharge immediately," Schumer said Wednesday. OFHEO director James Lockhart indicated he is willing to discuss loosening the requirement, but any decision will depend on "consideration of the financial condition of the company, its overall risk profile, and current market conditions."

Those factors continue to worry some people. As housing prices decline, the companies face the prospect of rising losses, as Fannie Mae's (FNM) fourth-quarter earnings report Wednesday and Freddie's numbers Thursday showed. Fannie lost $3.56 billion for the quarter and Freddie $2.5 billion, as rising delinquencies led to a sharp increase in provisions for credit losses.

Both firms warned that they expect those costs to keep rising in the coming year - a fact not lost on longtime critics of Fannie and Freddie. "It is irresponsible and dangerous to remove Fannie and Freddie's portfolio cap and talk about lifting their capital surcharge on the same day we learn of billions of dollars in new GSE losses," Sen. Chuck Hagel said in a statement Wednesday. "This makes no sense just weeks after Congress allowed Fannie and Freddie to purchase loans in the jumbo market, which is traditionally a riskier market. We should be increasing their capital requirement, not loosening it."

Critics note that hefty losses in the second half of 2007 forced Fannie and Freddie to raise $13 billion in new capital through sales of preferred stock. Wall Street is on the lookout for signs that the firms will need to raise even more money later this year, though most analysts don't expect to see any further capital-raising at least until the second half of the year.

Adding to anxiety swirling about the financial system, Fed chief Ben Bernanke testified Thursday that he expects to see some failures of smaller regional banks invested in real estate, though he said larger banks remain well capitalized. Bernanke's comments come a day after execs at JPMorgan Chase (JPM, Fortune 500) admitted that losses on home equity loans are now worse than the so-called stress case scenario under their forecasting models, and are expected to get worse.

Meanwhile, despite the Fed's recent run of interest-rate cuts, long-term rates have started to rise as investors worry about inflation. Freddie Mac (FRE, Fortune 500) said Thursday that 30-year fixed mortgage rates rose to 6.24% last week, up from 5.48% in late January and blunting the Fed's efforts to make houses more affordable by bringing down mortgage rates.

"Housing still has a ways to fall," says Len Blum, an investment banker at Westwood Capital in New York who previously ran the asset-backed securities group at Prudential Securities. Indeed, analysts at Credit Suisse wrote last week that prices could decline by 19% in the New York area and as much as 40% in some once-hot markets like Phoenix and Las Vegas, going by house-affordability measures tied to income and interest rates.

Even so, Miller says it's a good sign that government officials are doing what they can to break the debt market logjam. Fed chief Bernanke and Treasury Secretary Hank Paulson have been willing to try all manner of innovative measures, ranging from Treasury's attempt to prod banks to support structured investment vehicles to the Fed's term auction interbank lending facility, Miller says. He adds that it's important that policymakers continue to be willing to take action, because Miller is starting to see "spillover effects" from credit market failure, such as startup companies that can't line up financing from venture capital and angel investors.

OFHEO chief Lockhart says the feds are well aware of the risks associated with an expanded role for Fannie and Freddie, but they also know the markets need help. "We wanted to make sure they had some additional flexibility," Lockhart said on CNBC Wednesday afternoon. But, he added, "We have to be concerned in this kind of market that they do have a strong capital cushion. ... We want to make sure they are safe and sound."  To top of page

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