Regulator: Fannie, Freddie bailout not likely

NEW YORK (CNNMoney.com) -- Mortgage financing giants Fannie Mae and Freddie Mac could face further problems if home prices continue to plummet, but a taxpayer bailout is not likely, said the federal regulator charged with overseeing the two firms

James Lockhart, director of the Office of Federal Housing Enterprise Oversight, told CNNMoney.com Wednesday that the overwhelming problem for Fannie Mae (FNM, Fortune 500) and Freddie Mac (FRE, Fortune 500) is the decline in home prices in recent years and forecasts of further declines this year.

The firms don't originate mortgages themselves, but they buy loans made by lenders, providing a key source of funds flowing into the mortgages that follow their relatively tight credit standards.

They then bundled those loans together and sold securities backed by the flow of payments owed on those mortgages, known as mortgage-backed securities. To make those securities more attractive, they offered investors guarantees on those securities.

He said the home price declines are a bigger problem for the firms than other issues, including: credit market volatility; billions in unrecognized losses on their books; and hundreds of billions in investments in securities backed by subprime mortgages.

The decline in home prices reduces the value of mortgage-backed securities held by the firms, leading to losses, as well as causing a higher default rate in the loans that the firms have guaranteed. In addition, lax regulatory oversight of the firms - which operated with their own set of rules - led to a series of accounting problems and resulted in massive restatements of previous earnings and a lack of financial information made available to investors.

Lockhart said despite all those shortcomings, the firms' current capital position can help them weather at least some further declines.

"If house prices fall another 10%, the capital that they are raising now should see them through those kinds of problems. If housing prices fell [another] 20%, obviously there'd be a whole different scenario out there," he said.

Fannie, which on Tuesday reported a $2.2 billion loss over the first three months of the year, far worse than analysts' forecasts, also gave more bearish guidance for home-price declines. It is expecting drops of between 7% and 9%, down from its previous expectation of a 5% to 7%. Freddie is looking for a 10% decline this year.

Lockhart said Fannie and Freddie have been crucial to keeping funds flowing to mortgage borrowers who are eligible for so-called conforming loans that the firms are willing to back. Those borrowers have good credit scores and a down payment of 20% or more.

But during the housing boom that started early in the decade, the firms branched out, buying securities backed by far more risky loans, such as subprime mortgages. They also loosened the lending standards they required on loans they were willing to buy and guarantee, and allowed looser rules on property appraisals.

In a housing downturn in which most price decline forecasts have ended up being too optimistic, Lockhart conceded the market could see an even greater plunge in prices, especially without a pickup in confidence by potential home buyers.

"It is a risk," Lockhart said. "There was a bubble. House prices went up too high and after a bubble there's a correction. What we're concerned about....is trying to prevent an over-correction that could cause more dramatic fall in prices."

The continued slide in home prices, and rising losses for the firms, is prompting some economists and members of Congress to wonder if there will need to be a federal bailout of Fannie and Freddie, a rescue that could cost taxpayers more than $1 trillion, according to some estimates.

Lockhart said he's confident that a bailout will not be necessary if Congress passes a long-debated measure to grant his agency greater regulatory powers over the firms.

"I don't think it's a real possibility. If we're doing our job, it shouldn't happen," he said.

But he also said that OFHEO and the firms have little control over market volatility that can cause wide swings in the value of the firms' derivatives and trading portfolios, causing billions in losses. The decline in home prices and rising delinquencies has hit the value of those holdings.

"That swing can be pretty dramatic either way, although for the past three quarters it's been dramatic the wrong way," he said. He pointed out that OFHEO has expressed concerns in a recent report that the firms are not being conservative enough with their investment assumptions on those holdings.

Lockhart also repeated earlier concerns he and OFHEO have voiced about a move by Congress earlier this year to dramatically raise the size of the loans that the firms could purchase or guarantee, up to about $730,000 in some markets from the previous limit of $417,000.

One concern is that about half of those larger, so-called "jumbo" loans are concentrated in California, a state that has seen among the most severe home-price declines.

He did say, however, that Fannie and Freddie should be able to manage the higher limits because they are keeping a close watch on the quality of the loans.

Still Lockhart is encouraged by plans by both Fannie and Freddie to raise additional capital through stock offerings. Fannie announced plans to raise $6 billion as it announced its first quarter loss, news that sent its stock higher despite the disappointing financial results.

Lockhart said he wouldn't even be concerned if the firms turn to overseas sovereign funds, large pools of investment dollars controlled by governments in the Middle East and Asia, as a source of that capital, although he doesn't necessarily anticipate such a move. Wall Street firms in search of capital such as Citigroup (C, Fortune 500), Merrill Lynch (MER, Fortune 500) and Morgan Stanley (MS, Fortune 500) found funding from those sources.

Lockhart also defended the agency's decision to lower the capital ratios it had previously required of Fannie and Freddie, as they moved to clean up their accounting problems in recent years, even though they are facing what he described as their greatest challenges during the 15-year history of OFHEO.

He said at the time that they lowered the capital requirements in March, markets had seized up as a run on Bear Stearns (BSC, Fortune 500) required the Federal Reserve to arrange for the firm to be purchased by JPMorgan Chase (JPM, Fortune 500).

"From my viewpoint, it was helpful to unclog the markets," he said. The further reduction in capital requirements for Fannie announced Tuesday were justified by Fannie's announcement of its plan to raise excess capital above those required levels.