Fannie, Freddie proving too big to shrink

[December 31, 2009]  WASHINGTON (AP) -- The government's Christmas Eve pledge of unlimited financial aid to mortgage giants Fannie Mae and Freddie Mac is aimed at making sure the housing market doesn't take another turn for the worse and cause the economic recovery to unravel.

This insurance policy taken out by the Treasury Department will help keep mortgage rates low, and may wind up being a gift of sorts to struggling homeowners and banks. But there's a catch: The housing crisis is now likely to cost taxpayers much more.

The Obama administration's latest lifeline to Fannie and Freddie will cover unlimited losses through 2012, lifting an earlier cap of $400 billion. It also eases restrictions on the size of the companies' investment portfolios. That's a reversal of the Bush administration's September 2008 plan to shrink the size of the companies' holdings of mortgage-backed securities.

The action, which didn't need the approval of Congress, could position Fannie and Freddie to get more aggressive in dealing with the housing crisis, perhaps taking troubled mortgage investments off banks' books.

"They've cleared the decks to use Fannie and Freddie as a vessel for whatever they want," says Edward Pinto, a housing consultant who served as Fannie's chief credit officer in the late 1980s.

Treasury could also lean harder on Fannie and Freddie to help troubled homeowners avoid foreclosures -- and by extension the banks and other investors who own their mortgages. Many economists and housing experts say an existing $75 billion government program to prevent foreclosures isn't working fast enough, threatening the emerging signs of home price stability in many cities across the nation.

Boosting the firepower of Fannie and Freddie, which finance three quarters of all new mortgages, also should help keep rates on home loans low just as the Federal Reserve starts dialing back its separate $1.25 trillion program aimed at doing just that.

That's good news for the banking industry, which has benefited this year from homeowners refinancing their mortgages, says Jason O'Donnell, senior research analyst at Boenning & Scattergood Inc. "This is an initiative that spreads far beyond just Fannie Mae and Freddie Mac," he says.

But the trade-off is that the Treasury will have to cover much more than the $111 billion in losses at Fannie and Freddie it already has funded. Barclays Capital predicts the losses will range from $230 billion to $300 billion.

Both companies provide vital funding for home loans, buying mortgages from lenders, pooling them into bonds and selling them to investors with a guarantee against default. While they traditionally backed loans to relatively safe buyers, they dramatically lowered their standards during the housing boom, and those loans are now defaulting in higher numbers.

If the administration does lean on Fannie and Freddie to expand its foreclosure-prevention program, it would be pricey. If Fannie and Freddie were, hypothetically, to start forgiving a quarter of borrowers' mortgage debt, that would cost another $125 billion to help around 2.5 to 3 million borrowers, estimates Barclays analyst Ajay Rajadhyaksha.

The Treasury Department says its only motivation is to make sure investors remain confident that Fannie and Freddie can keep doing their jobs of buying the bulk of mortgages made in the U.S. and turning them into investments.

"These measures bring broad benefits to American homeowners and our economy," says Andrew Williams, a Treasury spokesman.

Fannie and Freddie must convince everyone from the Chinese central bank to hedge funds to individual investors that it is still safe to buy their debt securities, which they sell partly through weekly auctions. The two companies have sold $2.7 trillion in debt this year, according to Credit Suisse calculations.

Still, by making the change before year-end, Treasury sidestepped the need for an OK from a bailout-weary Congress, infuriating Republicans on Capitol Hill.

Treasury gave Fannie and Freddie a bigger lifeline "without any involvement, notice (or) dialogue with Congress," says Rep. Scott Garrett, R-N.J., a member of the House Financial Services committee, who called Wednesday for an investigation into the Treasury Department's actions.

Fannie Mae was created in 1938 in the aftermath of the Great Depression. It was privatized 30 years later to limit budget deficits during the Vietnam War. In 1970, the government formed its sibling and competitor, Freddie Mac.

After the housing market started to unravel in 2006, mortgage defaults soared, and the companies' losses mounted. By summer 2008, the companies weren't able to raise money, and their shares plunged. The Bush administration's hand was forced. It wound up taking over the pair a week before the collapse of investment bank Lehman Brothers. The government now has a 79.9 percent stake in each company, the maximum amount possible to still keep the companies off the federal budget.

Bush administration officials envisioned that Fannie and Freddie would ultimately be able to scale back their mortgage holdings by 10 percent a year, starting next year.

But the housing market remains shaky, with 11 out of 20 major cities showing price declines in October. Private investors remain wary of American mortgage investments. So Obama officials decided last week to give Fannie and Freddie more leeway, effectively allowing them to build up their portfolios next year, and then start cutting back in 2011.

Without this change, Fannie and Freddie would be forced to start selling mortgages from its portfolio early next year -- just as the Federal Reserve begins to retreat from that market. That would push up mortgage rates, and threaten the housing recovery.

Now they will be able to hold a combined $1.62 trillion in mortgage investments by the end of next year, compared with $1.36 trillion under the old rules. The result: Fannie and Freddie will have an additional $260 billion to invest next year, Credit Suisse calculates.

"They didn't want Fannie and Freddie to be out there selling mortgages when the future of housing is uncertain," says Credit Suisse mortgage strategist Mahesh Swaminathan.

[Associated Press; By ALAN ZIBEL]

AP Business Writer Sara Lepro contributed to this report from New York.

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