Government Sponsored Enterprises Implode Again

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Mike Larson takes a closer look at just how much trouble Fannie Mae and Freddie Mac are in. In this issue of Money and Markets, Mr. Larson discusses how Fannie Mae and Freddie Mac buy hundreds of billions of dollars worth of home mortgages from lenders for their own portfolios.

Shares of the two Government Sponsored Enterprises, GSEs, just recently imploded again: Fannie Mae lost 39% between last Friday and yesterday's close, while Freddie Mac dropped 46%. Freddie Mac fell to its lowest in almost 18 years, Fannie Mae to its lowest in more than 19. Investors are dumping their preferred shares and they're selling off Fannie Mae and Freddie Mac bonds as well. The message from the markets is coming through loud and clear: these companies are in big, big trouble.

Fannie Mae and Freddie Mac play a crucial role in providing liquidity to the mortgage market. The two giants buy hundreds of billions of dollars worth of home mortgages from lenders for their own portfolios. They also guarantee bundles of home loans called mortgage-backed securities (MBS). Essentially, they promise to pay investors who buy MBS timely payments of principal and interest even if the underlying borrowers default on their loans; this is called the securitization process. These processes grease the wheels of the mortgage market. Banks can make loans, turn around and unload them to Fannie Mae and Freddie Mac, then use the money they get back to make new loans.

During the housing bubble, vast quantities of home loans were also made and securitized by private market participants, rather than Fannie Mae and Freddie Mac. This allowed the subprime and Alt-A mortgage markets to explode. As long as some investor further down the pipeline was willing to buy and invest in mortgages and mortgage bonds, front-end lenders and brokers were able to make more and more loans.

However, things have changed. Beginning in 2007, the subprime market started imploding. Rising delinquencies on the underlying loans caused losses to mount on mortgage investments. Falling home prices only made a bad problem worse. Liquidity drained out the market as investors started dumping subprime mortgage bonds.

For a while, Wall Street and Washington tried to sell Main Street on this idea that it was a subprime problem only; they said it was contained. The Money and Markets gurus told you that the problems in the subprime market were only the start of a massive crisis that would work its way up the mortgage food chain.

Problems started to emerge in Alt-A loans. Those are mortgages made to borrowers with higher credit scores, but other risk factors. One of the biggest Alt-A lenders during the bubble was IndyMac, which just failed and was taken over by the FDIC.
As for home prices, they show little sign of bottoming out. Figures from S&P/Case-Shiller show home prices down 15.8% in May from the same month a year earlier. That's the largest drop on record. Prices fell in all 20 metropolitan areas the firm tracks. Las Vegas (-28.4%), Miami (-28.3%), Phoenix (-26.5%), and multiple markets in California (-24.6% in L.A., -23.2% in San Diego, and -22.9% in San Francisco) are leading the way. Lenders are responding by tightening lending standards across the board, preventing many troubled borrowers from refinancing into new loans.

Losses are surging at Fannie Mae and Freddie Mac. Fannie Mae bled $2.3 billion, or $2.54 per share, in red ink during the second quarter. That was the fourth straight quarterly loss and much worse than the 72-cent forecast that analysts were carrying. Freddie Mac lost $821 million, or $1.63 a share compared with a profit of $764 million, or $1.02 a share, in the year-earlier period.

Freddie Mac's credit loss provision surged to $2.63 billion from $469 million a year earlier. The company also revealed that it had roughly 22,000 foreclosed homes on its books. That was the most in the almost four decades it has been operating. Fannie Mae's credit losses jumped 66% to $5.3 billion. The company said it will cease buying Alt-A loans and slashed its dividend by 86% to preserve capital.

Investors are responding by dumping many of their existing stock and bond positions and by demanding that Fannie Mae and Freddie Mac pay up to borrow new money.

Treasury Secretary Henry Paulson recently tried to assuage these kinds of fears by obtaining the authority to buy an unspecified amount of equity in the Government Sponsored Enterprises (GSEs). He also was granted the right to provide the GSEs with an unlimited credit line from the government. Paulson suggested at the time that the mere existence of this authority would obviate the need to actually use it. This allowed the administration to suggest that the cost to taxpayers would be limited or even nonexistent.

But the market just isn't buying it anymore. Investors are voting with their pocketbooks. They're rendering a simple verdict that the GSEs probably don't have enough capital to weather the mortgage crisis and cover all the losses they're facing. So they're going to need government support.

"What is the ultimate outcome here? That depends on the credit markets. If Fannie Mae and Freddie Mac can keep raising money, even at more expensive levels, then they can drag this thing out for a while. But if debt and stock buyers completely step away, forget it. Who's going to give Fannie Mae and Freddie Mac money to keep operating in that event? The government or more accurately, taxpayers like you and I," Larson states.

To read this issue online, please visit:
http://www.moneyandmarkets.com/Issues.aspx?The-GSE-End-Game-2116

About Mike Larson and Money and Markets

Mike Larson joined the company in 2001, and has more than 10 years of experience researching and writing about personal finance, investing, and the housing and mortgage industry. In 2003, Mr. Larson was named associate editor of the company's monthly Safe Money Report. In this role, he is responsible for writing and editing as well as analyzing trading opportunities for clients. Mr. Larson is also a regular contributor to the company's daily e-letter, Money and Markets.

Before joining Weiss Research, Mr. Larson was a personal finance reporter for Bankrate.com, where he wrote extensively on mortgage lending, banking, residential real estate, and Federal Reserve Board policy. His responsibilities included analyzing economic data and interest rate trends for a weekly column and developing rate forecasts for a regular index feature. Previously, Mr. Larson held positions at Bloomberg News and the Boston Herald.

Recognized as an interest rate and mortgage market expert, Mr. Larson's views have been quoted in the Washington Post, Chicago Tribune, Dow Jones Newswires, Reuters, Sun-Sentinel and the Palm Beach Post. He has also appeared as an investment expert to discuss the housing market on CNBC, CNN, and Bloomberg Television. His writing has been acknowledged by both the National Association of Real Estate Editors and the Massachusetts Press Association.

Among the first analysts to call the housing slide, Mr. Larson's new policy paper, "How Federal Regulators, Lenders and Wall Street Created America's Housing Crisis: Nine Proposals for a Long-Term Recovery" has received broad media coverage following its July 2007 submission to the Federal Reserve and FDIC. Mr. Larson holds B.A. and B.S. degrees from Boston University.

Money and Markets (http://www.moneyandmarkets.com) is a free daily investment newsletter from Dr. Martin Weiss and Weiss Research analysts offering the latest investing news and financial insights for the stock market, including tips and advice on investing in gold, energy and oil. Weiss Research, Inc. is located in Jupiter, Florida. For more information about our editors, or to set up an interview, please contact Jennifer Moran at 561-627-3300 or visit http://www.moneyandmarkets.com.

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