Investors Dump Securities From Fannie, Freddie
Mortgage Sector Strongholds Falter

By David S. Hilzenrath
Washington Post Staff Writer
Friday, March 7, 2008

As the business of making and trading mortgages has deteriorated over the past year, one of the few market segments still functioning smoothly was that managed by Fannie Mae and Freddie Mac, two companies chartered by the government to keep mortgage money flowing.

Now, even their part of the market appears to be weakening.

The prices of mortgage-backed securities guaranteed by Fannie Mae and Freddie Mac have plunged lately as supply has grown faster than demand. That indicates that their ability to prop up the lending system has declined.

"The implications are quite onerous because this was the one market that was functioning, and moreover, this is the market that the administration was counting on to maintain its liquidity so that it could help all these troubled homeowners," said Douglas A. Dachille, chief executive of First Principles Capital Management.

"If this continues, this is going to be very bad for home prices," Dachille said.

Fannie Mae, based in the District, and McLean-based Freddie Mac package mortgages into securities for sale to investors, guaranteeing to pay the principal and interest if the borrowers default. That enables lenders to move mortgages off their books and replenish the funds they use to issue new mortgages.

Historically, guarantees from Fannie Mae and Freddie Mac have been regarded as nearly as solid as those of the U.S. government.

The perceived risk of Fannie Mae and Freddie Mac mortgage securities is reflected in the spread between the interest rates on those instruments and the rates on U.S. Treasury securities with comparable terms. Widening spreads -- in other words, increasingly high rates on Fannie Mae and Freddie Mac securities relative to Treasurys -- indicate that investors' appetite for the firms' securities is declining.

Measured one way, yesterday's spreads for the government-sponsored enterprises were the widest since 1986, at 2.48 percentage points, said Kevin Cavin, a mortgage strategist at FTN Financial Capital Markets.

Troubled investment funds have been dumping Fannie Mae and Freddie Mac securities to cover losses on less-marketable mortgage investments, Cavin said. Yesterday's spread was the result of massive selling "by leveraged investors, namely the hedge fund community, who have had to sell their most liquid and highest quality assets . . . to meet margin calls from their lenders because their weakest quality assets . . . have seen extremely sharp declines in market value and there are few if any buyers of those securities," Cavin added by e-mail.

Meanwhile, brokers that allowed investment funds to buy Fannie Mae and Freddie Mac securities with borrowed money are requiring them to put up additional collateral, Dachille said.

The widening spreads "signify there's volatility in the market for our securities," said Freddie Mac spokesman Michael Cosgrove. Nonetheless, "it's been a very liquid, very orderly market," Cosgrove said.

Fannie Mae spokesman Brian Faith declined to comment on the widening spreads.

Fannie Mae and Freddie Mac have been largely prohibited from taking on the biggest and riskiest loans. Until recently, they were barred from taking on individual mortgages of more than $417,000. To help boost the nation's flagging economy and increase the availability of "jumbo" mortgages, the government recently boosted the maximum amount in parts of the country with relatively high housing costs. In the Washington area, the limit was raised to $729,750, a federal agency announced yesterday.

The impact of that step depends in part on the ability of Fannie Mae and Freddie Mac to sell securities based on the larger mortgages.

Federal policymakers also have been counting on Fannie Mae and Freddie Mac to provide relief for homeowners facing foreclosure by taking on and renegotiating their loans.

In addition to securitizing mortgages and mortgage-backed securities, Fannie Mae and Freddie Mac buy them for their own investment portfolios. But their ability to buy is limited by their need to hold prescribed amounts of capital as a cushion against losses.

The deterioration in the market for Fannie Mae and Freddie Mac securities heightens a dilemma facing their regulator, the Office of Federal Housing Enterprise Oversight: whether to relax the companies' capital requirements.

Reducing the capital requirements could enable the firms to buy more of their own securities and compensate for the lack of demand from other investors. But doing so could also expose them to greater risks.

Both companies are already facing serious trouble. They have been reporting billions of dollars in losses and have issued billions of dollars of preferred stock to shore up their diminished capital. Meanwhile, their stocks have been sinking.

"OFHEO continues to believe, as do the Enterprises, that a strong capital position is extremely important in this market," OFHEO director James B. Lockhart III said in a statement.

Fannie Mae's stock yesterday fell 10.6 percent, to $21.70, and Freddie Mac shares fell 6.9 percent, to $20.14. Those were their lowest closing prices since the mid-1990s, according to Morningstar, and far from their highs for the past year of $70.57 and $68.12, respectively.