Recipe for Fixing Fannie and Freddie: More Money, More Loans, More Time

Fannie Mae (FNM) and Freddie Mac (FRE) find themselves in the unenviable position of having cornered the market in mortgage lending, only to be unable to make enough money to be profitable. The two taxpayer-funded mortgage servicers are trying to contain rapidly-expanding losses due to shrinking property values during one of the worst housing slumps in history, while also providing liquidity to help stabilize the housing market and create enough profit to get themselves off life support. Ironically, their road to profitability may lie in their ability to use even more taxpayer funds to finance higher-quality loans that are structured to increase in value as interest rates rise when the economic recovery finally gains steam.

The two much-maligned institutions, which were bailed out by U.S. taxpayers in September 2008, are under more pressure than ever to pay that money back now that attention has been focused on bringing down the nation's projected $1.56 trillion deficit for 2010. After it receives the additional $15.3 billion capital infusion it requested from the U.S. Treasury last week, Fannie Mae will have borrowed $76 billion since being forced into conservatorship; Freddie Mac has borrowed just over $50 billion.

Even though taxpayers don't like the amount of money those institutions have borrowed, they love getting their loans from Fannie and Freddie. According to Bloomberg, the two companies owned or guaranteed about 75% of all residential mortgage loans made last year and accounted for more than $5 trillion in mortgages, nearly 60% of the total market.

Delinquencies Have Further to Rise

Both entities reported 2009 fourth-quarter earnings in February, with Fannie Mae's loss growing from $59.8 billion in 2008 to $74.4 billion last year, and Freddie Mac's loss shrinking from $50.1 billion in 2008 to $25.7 billion in 2009. Most analysts projected significant problems ahead for both institutions. In separate notes, Standard & Poor's credit analysts Daniel Teclaw and Vandana Sharma outlined the mounting number of delinquent loans in the two mortgage companies' portfolios:

S&P expects charge-offs at both entities to accelerate as more delinquent loans, including modifications, are moved through the loan-resolution process, and foreclosures and property seizures occur. With the number of delinquent loans and charge-offs increasing dramatically for Fannie and Freddie, it's reasonable to expect that they may need to borrow even more money from taxpayers to pay for the charge-offs until other securities generate profits.

Quality Loans + a Bit of Inflation = Rising Portfolio Values

To generate profits, Steve Stahler, president of asset management firm The Stahler Group, suggests the two entities begin replacing the bad loans on their books as quickly as possible by accelerating financing of higher-quality loans that will become more valuable over time. With the commercial real estate market looking like it's heading for a fall, Stahler reasons that investors will rush back to the residential mortgage market, where losses appear to have peaked. In an environment where yields have been down, he reasons some of the loans in the Fannie and Freddie portfolios could become hot commodities if certain economic conditions break right. Who would buy loans from so-called failed institutions? Hedge funds and private-equity funds, which Stahler says are "bottom-fishing" for investments with higher yields.

"If Fannie and Freddie can make quality loans, as we get into an inflationary phase, interest rates are going to go up -- so they'll make a little money, and then inflation is going to push the values of their portfolios up," Stahler said. "I think we're two years out from that happening."

There are signs that Fannie and Freddie may be implementing a strategy similar to the one Stahler describes. In February, Fannie Mae announced that it would significantly increase its purchases of delinquent loans from single-family mortgage-backed security trusts. Freddie Mac agreed to do the same. Fannie Mae confirmed the move on Monday.

"We anticipate that we will purchase approximately 150,000-200,000 loans from MBS trusts in the month of March, and expect that we will continue purchasing loans in each of the subsequent few months until we have substantially reduced the current population of loans that are four or more months delinquent," the company said in a statement.

Geithner Pushes to Postpone Political Pressure

Additionally, to eliminate the risk in much of its portfolio, on February 25, Freddie Mac announced that after Sept. 1, 2010, it would stop purchasing and securitizing "interest-only mortgages," some of the most risky loans made during the housing boom. Both moves should make securities sold and packaged by the two mortgage giants more attractive to investors.

The prospect of having theses two organizations borrow more taxpayer dollars is unattractive, and Republicans are mounting an effort to hold public hearings on the bailout of Fannie Mae and Freddie Mac. Treasury Secretary Timothy Geithner has said in news reports that the administration will delay announcing how it intends to resolve the open-ended bailout of the two institutions until 2011. That may give the administration enough time to come up with a viable solution that saves the housing market and ends the bailout, and also allows the economy time to begin recovering in a way that will stimulate profit growth at the two companies. The U.S. General Accounting Office released a report in September that explored options the government could take to deal with the problems at both enterprises.

Unfortunately, Fannie and Freddie may not have the luxury of enough time to wait for the economy to recover, or the ability to continue drawing on taxpayer funds while it does. Not many people give them a chance of returning to profitability. As Morningstar equity analyst Matthew Warren skeptically wrote in a note about Fannie Mae, "Despite a potential turnaround in credit fundamentals, we think Fannie is already too far gone and advise against speculating in the firm's common equity."