'Piggyback' Loans Allowed by Freddie Fed Mortgage Risks

Last month, Freddie Mac announced a $2 billion loss for the third quarter. Since early October, the company's stock has dropped 41.5 percent, erasing billions of dollars of shareholder wealth. At a time when some policymakers hoped it would help ease a credit crunch by serving as a loan buyer of last resort, Freddie Mac was selling mortgages to shore up its own financial condition. Last week, it cut the dividend it pays stockholders by half and borrowed $6 billion from investors to meet federal capital requirements.

Like its competitor Fannie Mae, Freddie Mac plays a major role in the nation's housing finance system by packaging pools of mortgages into securities for sale to other investors and by buying mortgages itself.

Freddie Mac's problems are similar to those weighing on many of the nation's largest financial institutions. In pursuit of profit, and to retain market share, it invested in riskier loans. Some came with the option of low monthly payments that escalated over time. Some required no information about a borrower's income or assets. In many cases, the loans made it possible for people to buy homes they could not otherwise afford.

Now, borrowers are defaulting, foreclosures are mounting, home prices are falling, and easy credit is drying up, feeding a downward spiral.

Freddie Mac's diversification into certain types of alternative loans took a big jump in 2005, well after a 2003 accounting scandal exposed deep flaws in the company's internal controls and a new chief executive, Richard F. Syron, was brought in to clean up the mess. In its annual report for 2005, the company said that it expected the alternative loans to default more often than traditional loans and that it had factored in the risk.

Freddie Mac has the potential to influence lending practices by setting conditions for the loans it accepts. But company executives said yesterday that Freddie Mac's power was eroding as investors entered the market.

Amid a loosening of industry standards, Freddie Mac could not afford to sit back and let the market pass it by, the executives said.

"I think what happened over time is, we found that our own caution was making us less and less relevant, and we weren't sure, quite frankly, that our competitors, you know, on the street were being crazy," Piszel, the chief financial officer, said.

"Could we have run for the hills and said we're not going to do any of that?" Piszel asked. "What if things didn't go down? We would basically be just taking our whole future and giving it away."

This year, as the market deteriorated, Freddie Mac's investment in alternative loans grew. For the first nine months of 2007, nontraditional loans made up about a third of Freddie Mac's mortgage purchases, up from almost a quarter in the first nine months of 2006.

Unlike most other players in the mortgage business, Freddie Mac is required to operate under a congressional charter that imposes such restrictions as the 80 percent rule.

That requirement was meant to insulate the company from losses.