The Cracks in Congress's Housing Rescue

Democrats in Congress got their way when they pushed through legislation that would expand the powers of the Federal Housing Administration (FHA), the government agency that supports low-cost housing, to back $300 bn in refinancings of upside-down mortgages, in exchange for getting banks to slash the principal balance borrowers owed on the loans.  

The US's largest mortgage funding companies, Fannie Mae and Freddie Mac also play a big role in the housing rescue, one idea being they would get to hold jumbo loans amounting to more than $417,000, in return for supposedly much stricter regulation, long overdue since the two were found to be misstating earnings a few years ago.

But yesterday's report from Lehman Bros. (LEH) rocked both these stocks, as it talked about a new accounting rule change from the Financial Accounting Standards Board, FAS 140, that would force not just Fannie and Freddie but all of the financials to put back on the balance sheets more than an estimated $7 tn in total assets now sitting in off-balance sheet vehicles.

Fannie and Freddie buy mortgages and repackage them into securities rubberstamped with their implicit government backing (though they are publicly traded companies), plus they also hold these securities on their balance sheets and a sizable amount more in off-balance sheet vehicles. Lehman says Fannie alone has about $2.27 tn of off-balance-sheet mortgage-backed assets and Freddie has $1.42 tn.

Why this report was a newsflash is an imponderable, as FAS 140 has been out their for months (see blog "The Bank of America Housing Bailout Bill"), but in this panicky market the Lehman report shot through the markets like a rocket, with trading volume heavy and both Fannie Mae and Freddie Mac plunging to share levels not seen since 1992 and 1993 respectively. Fannie's shares have lost 77% of their value over the last year, Freddie, 82%. 

The idea being that all financials, not just Freddie and Fannie, would have to ante up even more capital if they are not exempt from the rule change, at a time when balance sheets have already been ravaged. Which is why most of the financials got socked in trading, including Morgan Stanley (MS), Merrill Lynch (MER) and Citigroup (C).

Now the debate is whether the FASB will exempt these two US mortgage financing giants from the rule change. At the same time, Congress's FHA rule change supposedly will help Fannie and Freddie, since this wing of the government can now refinance loans that "Mr. and Mrs. No Income, No Assets" bought, which Fannie and Freddie held as repackaged securities, those cut and paste jobs hanging like a drunken daisy chain of nonsense around the globe, but since the FHA has stepped in, they may not have to write them down, a maximum $300 bn worth, the thinking goes. The plan would also raise the dollar limit on the mortgages Fannie and Freddie buy and insure, either $625,000 per loan under the Senate version or $725,000 in the House's bill.

But while some media watchers scratch their heads over what's going on, a look at Fannie's and Freddie's balance sheets reveals the scary condition they are in.

Fannie and Freddie in total have a colossal $5.3 tn portfolio, which equals the total amount of US government debt held by the public, sitting perilously atop a thin sliver of a wedge of a capital cushion in the form of shareholders equity to support that book of business at $54 bn, $38.8 bn for Fannie and $16 bn for Freddie, (Freddie is down from $26.7 bn at year end 2007.)

That $5.3 tn amounts to $1.6 tn in debt and $3.7 tn in mortgages they securitized and now guarantee. The two held securities propped up by subprime loans amounting to a total of nearly $260 bn, with Freddie holding the lionshare, though the two say they have whittled that book of business down to $206 bn.

Loans securitized at the height of the bubble are proving most nettlesome, with souring loan vintages made between 2005 and 2007 chewing through their portfolios, more than 50% estimated at Fannie and more than 55% at Freddie.

But check this out. Both Fannie and Freddie have dangerously low tier one capital, at just around 3.6% of their risk weighted assets, or mortgage credit exposure, just over half of what a bank typically holds at 6% (high too, given that banks as well have shoved items off the balance sheet).  

And that capital is not measured on a fair value basis, meaning, what the assets would be worth if they were dumped in a credit market that's in a blackout mode. Fair value them, and their core capital can't hold steady above water.

A philosophical exercise, to be sure, as the two are held to maturity enterprises, meaning, they back loans to maturity.

But an enlightening one as more than one million homes are in foreclosure, banks repossessed twice as many homes this spring versus last year, and between eight and nine million homeowners are upside down in their loans with keys being mailed back to banks, turning these assets into zombie securities, backed by dead loans walking.

Fannie and Freddie are thought to be too big to fail-meaning, yes you US taxpayer have to foot the bill for their impenetrable stupidity. Which is why new Congressional legislation gives the Office of Federal Housing Enterprise Oversight (OFHEO) greater leeway to push these two behemoths to ante up more capital--and gives the government stronger receivership dictates in case they teeter on the brink of bankruptcy. 

An event investors should be worried about. Despite their creaky condition, despite the fact that Fannie and Freddie have lost investors a total of $11.1 bn in the past three quarters, the two mortgage funding companies have clattered ahead.

As Wall Street's mortgage-backed securitizations dried up, the world turned to Fannie and Freddie for help. Their portion of the mortgage-backed securities (MBSs) market rose to a stunning 84%, more than two and a half times the 33% just two years ago, just when the housing bubble was inflated to bursting in 2006.  

However, Fannie booked losses in the last two quarters, Freddie has spilled red ink three straight quarters running, and both companies are expected to teeter into the red in their fiscal second quarters, too. Yet, each have an implicit government backing as they each supposedly have a $2.25 bn pipeline into the US Treasury.

Which is why when the markets were suicidal over the Bear Stearns collapse back in March, the markets lost their abiding faith that those sums were not enough, the idea being that they were too big to fail, as the spread on Fannie and Freddie's securities above Treasuries hit junk bond levels and beyond, dipping since then but still inordinately high.

What is the market telling you? 

That the US government cannot rein in these two out of control housing gorillas. Capital levels are thinner than a dime, with even its watchdog, James Lockhart, director of the Office of Enterprise Housing and Oversight, recently warning that they pose a "point of vulnerability" due to their sky-high leverage.

Now Freddie and Fannie, like the bond insurers, would aver that they merely guarantee these securitizations, a thin-lipped defense given their chaotic handling of their businesses and given that these securitizations are blowing up right and left, showing that the backstop they are supposed to provide the market is weaker than the chain link fence at a Little League game with a cannon blast aimed at it.

To be sure, Fannie and Freddie have been scrambling to raise capital with equity and preferred stock issuances. A total of $25 bn has been raised, just about twice their $11.1 bn in losses, and with new FAS 140 accounting change bearing down, Lehman estimates the twins need to raise about $75 bn more in capital. Fannie would need to raise $46 bn to meet capital requirements, while Freddie would need to raise $29 bn, Lehman said. Ridiculous, yes, as Fannie already sports a market cap of about $15.6 bn, Freddie, $7.7 bn.

Hard to do, when the sovereign wealth funds are sitting on the sidelines as Goldman Sachs reports that of the 42 or so stock issuances since last August, 39 are under water.

The problem is, as with all financials, did they raise enough in the first go around, with the idea being that companies should overdo it with capital raises, and not do them piecemeal. Fannie has raised $6.5 bn while Freddie is in the process of raising $5.5 bn through new common, though the latter is hitting a wall lately because who wants to buy its stock when the shares are flying south faster than a goose in winter. And why buy when more dilution is headed your way?

Which is why the private mortgage insurers now are so vital to the health of Fannie and Freddie. US law restricts both from buying loans that amount to more than 80% of a property's value, but as in all bubbles, money was tossed at most comers, including borrowers who bought loans with little to zero equity in the home, backing their loans with mortgage insurance.

Watch the way both Fannie and Freddie's shares play when the private mortgage insurers, like Radian Group (RDN), parent of Radian Guaranty, PMI (PMI) and MGIC (MTG), hit the skids. Which is happening now.