New Paths for Mortgage Giants

The companies are also trying to cope with a mortgage industry much freer in its lending and much more likely to hold mortgages in-house for longer periods and with consumers more willing to take on riskier, adjustable-rate loans to keep their monthly payments down.

Fannie Mae, founded during the Great Depression to keep the home mortgage market liquid, and Freddie Mac, chartered in 1970 to compete, built their businesses around the fixed-rate, 30-year mortgage and a more conservative banking climate. Their presence, as a source of cash and a standard-setter for how to rate mortgage applicants, encouraged banks to lend money. Lenders could initiate loans and pocket the fees, confident that as long as the borrower met Fannie Mae's or Freddie Mac's standards, they could resell the loans to one of them, get their capital back, and make another loan.

The companies tended to shy away from delving too deeply into adjustable-rate and other unconventional mortgages, regarding them as too risky. Such loans, however, have soared in popularity and now account for more than 30 percent of U.S. home mortgages issued in 2004, said Dale Westhoff, Bear Stearns's senior managing director of mortgage research.

In contrast, loans that conform to Fannie Mae and Freddie Mac's basic guidelines -- the companies cannot, for example, accept loans of more than $417,000 because their basic mission is to support middle- and low-income housing -- have fallen from more than 62 percent of loans issued in 2003 to less than 36 percent of loans issued this year, according to Inside Mortgage Finance.

"So much of the new mortgages don't fit into their framework," said William C. Apgar Jr., a former assistant housing and urban development secretary now with Harvard University's Joint Center for Housing Studies. "Fannie and Freddie did a big service taking a relatively unorganized system and saying, 'If you present a mortgage of this type, we can bundle them together and sell them to investors.' Now the flow of product is so much more complex and requires so much information," he said.

"Fannie and Freddie haven't figured out a way to get into that segment of the market," Apgar said. "They're constrained because of their concern about how well they can manage that risk."

Demand for adjustable-rate mortgages has begun to taper off lately as interest rates have risen. But housing finance experts say adjustable-rate mortgages are here to stay.

"It's unlikely Fannie Mae and Freddie Mac will ever see the market shares they saw in the early 2000s," Westhoff said. "We will continue to see a higher share of adjustable-rate mortgages than we've seen historically."

Fannie Mae and Freddie Mac are not willing to let the market pass them by. Executives of both companies argued that they will have to adapt to fulfill their government-chartered mission to keep money flowing into the housing market.

"As we look at our business, we realize we have a special role to fulfill in the market," Mudd said. "Various strategies we may consider clearly need to be examined in terms of our mission to support the market and help low- and middle-income families." Mudd said that after the firm puts its accounting problems behind it, it will "participate in more markets with more products . . . and more flexible products for people with a credit blemish on their record and for first-time minority home buyers."

Freddie Mac already has stepped up its investment in adjustable-rate mortgages, although about 80 percent of its holdings still are long-term, fixed-rate loans.

As the firms look for new ways to grow, both will have to be careful not to grow too much. Their investment portfolios, which grew rapidly in the 1990s, were a major source of the accounting violations at both companies. Congress is considering legislation that would give a new regulator for Fannie Mae and Freddie Mac varying levels of authority to scale back the size of their holdings. A Senate proposal would limit the kinds of assets they can hold.

Fannie Mae and Freddie Mac have already been forced to become smaller to satisfy regulatory requirements, shedding a combined $200 billion in portfolio holdings.

"The market is so competitive that even if our favored and friendliest customer sees us as being off by a [tenth of a] point, they're going to sell the business to somewhere else," Mudd said. "We've got to build the company to manage that and be ready for it."