2008-03-20

Fannie and Freddie have been naughty in the past, but after a short stretch of good behavior, the U.S. government is giving them a lot of leeway to increase their business, hoping they can calm the troubled American mortgage market. The risk is that even if the troublesome twosome behaves, the unruly mortgage market could end up costing taxpayers a bundle.

On Wednesday, the Office of Federal Housing Enterprise Oversight, Fannie Mae and Freddie Mac announced a major initiative to bolster the U.S. mortgage business by increasing their lending authority to the tune of roughly $200 billion.

Fannie and Freddie have been involved in a string of accounting scandals this decade, rigging accounting to increase management bonuses and the like. Moreover, the two companies, born of government agencies but morphed into private-sector companies, seem to want to grow for the sake of getting bigger. They currently own or guarantee a combined $4.9 billion in home-loan debt, and, including the new authority granted Wednesday, can provide $2 trillion of new support to America's battered housing sector this year. Last year Freddie and Fannie handled a combined $1.3 trillion in mortgages.

The U.S. government has been of two minds about Fannie and Freddie. There have been calls to temper their growth, but businesses that help taxpayers buy homes are popular with Congress. On the other hand, even though they are legally private companies, investors generally think the two are too big for the government to allow them to fail. That means that if widespread defaults on mortgages were to strain their finances, the United States would be forced to bail them out.

What the oversight agency did on Wednesday was to reduce safeguards put in place in 2004 after the two companies were caught playing fast-and-loose with their books. The safeguards came in the form of enhanced capital requirements.

Most lenders are required to reserve some capital to account for bad loans. In the case of Fannie and Freddie, the capital is 0.45% of the loans that they guarantee and 2.5% of mortgages that they own themselves, which are financed with bonds they issue in their own names. To punish them for their misdeeds, the government required them to total those numbers and add 30%. On Wednesday, the penalty was reduced to 20%, which will have the effect of allowing them to expand lending. The two companies are also planning to raise new capital, which will allow further mortgage-making.

The good side of giving Fannie and Freddie expanded authority is that the money could be expected to support housing prices in America, which have come under pressure thanks to imprudent lending earlier in this decade. People who couldn't or wouldn't qualify for loans that conformed to standards for Fannie and Freddie guarantees were easily able to borrow from other sources. This had the effect of boosting U.S. home prices. But that bubble started to deflate around the start of 2007 when subprime borrowers began to miss payments, in part as housing prices cooled but also because low-cost introductory mortgage rates were ending and they couldn't afford the higher amounts.

As the mortgage market went into reverse, home prices began to fall, creating a snowball effect: borrowers who couldn't afford their payments put their homes up for sale, pushing prices ever-lower as the growing supply met decreasing demand. Lenders who had financed the boom, often via exotic securities, stopped lending.

That leads to the downside of Wednesday's move: if prices continue to decline and the government-sponsored enterprises increase their lending, they'll just be taking a growing chunk of a rancid pie, with less of a cushion from their capital reserves. (See "Sacrificing Fannie and Freddie")

Investors weren't buying that doomsday scenario on Wednesday, however. Despite a weak stock market, Freddie Mac shares rose 14.9%, or $3.88, to $29.90, while Fannie jumped 8.8%, or $2.49, to $30.71. On the other hand, while those gains were impressive, they were from historically low levels. In November 2006 prior to the onset of the subprime mortgage crisis, Freddie traded at $67.97 and Fannie at $58.30.

The Wednesday decision follows other government moves to loosen the strings on the two lenders. February's $168 billion U.S. economic stimulus plan temporarily increased the cap on mortgages that the companies can purchase or guarantee, to $729,750 in high-cost markets from $417,000. On March 1, Fannie and Freddie were released from a combined $1.5 trillion cap on their mortgage-investment holdings after filing timely financial statements following multibillion-dollar accounting scandals.

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