By David S. Hilzenrath
Washington Post Staff Writer
Wednesday, May 7, 2008; A01

Fannie Mae, one of the main sources of mortgage funding and a barometer of the housing market, yesterday reported that home prices fell faster than it expected during the first quarter, contributing to a $2.2 billion loss for the company.

The company had been predicting that the toll from defaults and foreclosures would worsen this year, and yesterday it revised its forecast to predict even higher credit losses ahead.

The loss came as the strain of the recent credit crunch continued to roil the housing and finance industries. Yesterday, the Swiss banking giant UBS reported an $11 billion quarterly loss and said it would cut 5,500 jobs. Meanwhile, the Legg Mason investment firm lost more than $250 million in its fourth quarter as it set aside money to support its money-market funds.

Fannie Mae and its federal regulator responded to the deteriorating situation by announcing steps that could strengthen the company and the housing market -- or put the finance giant in an even deeper hole.

The government is relying on Fannie Mae to prop up the troubled real estate market, and the company is eager to expand its business. The challenge is to do both without making Fannie Mae the next bailout candidate.

Chartered by the government to keep mortgage money flowing, the shareholder-owned company packages mortgages into securities for sale to investors, promising to make the payments if the borrowers default. The company also buys mortgages directly. Those activities help lenders get mortgages off their books and replenish the funds needed to make more loans.

Altogether, Fannie Mae, based in the District, owns or guarantees nearly $3 trillion of mortgage-related investments and is responsible for about half the securities being issued to fund home mortgages.

The Office of Federal Housing Enterprise Oversight said yesterday that it plans to allow Fannie Mae to operate with a thinner financial cushion. That would be the second reduction in the required safety cushion since March, and the regulator said it intends to make a third reduction in September.

Tying up less capital as a cushion against losses enables the company to buy and guarantee more loans, but it could also put the company at greater risk.

OFHEO's plan to reduce the capital requirement was conditioned on completion of a plan Fannie Mae announced yesterday to raise $6 billion of new capital from investors. Chief executive Daniel H. Mudd said the company would use the added capital to shore up its financial strength, "pursue the best business opportunities we have seen" and help the housing market recover.

Those goals are potentially at cross-purposes. Holding on to the new capital would give Fannie Mae a bigger safety cushion, but spending it could leave it vulnerable to a further downturn.

The company didn't say how it would balance those objectives.

Each dollar of additional capital it raises would enable it to increase its mortgage holdings by about $35 or expand its mortgage guarantees by about $193, according to OFHEO.

To help homeowners caught in the market crisis, Fannie Mae said it would take the unusual step of allowing borrowers whose homes are worth less than their mortgages to refinance up to 120 percent of the property value. That option would be offered to homeowners whose loans are owned by Fannie Mae and who remain up to date on their mortgage payments.

Much of the $6 billion of common and preferred stock the company issues to raise money would dilute the value of current investors' shares, and Fannie Mae plans to compound the injury by cutting the dividend it pays shareholders by 29 percent in the third quarter.

In a conference call with Wall Street analysts, Mudd said the trade-offs the company is making now to extend its reach will pay off for shareholders over the long run.

"We will feast off this . . . business that we're putting on for many years to come," Mudd said.

Fannie Mae's stock rose $2.52, nearly 9 percent, to $30.81 a share.

Fannie Mae estimated that it exceeded its capital requirement by $5.1 billion. OFHEO's agreement to ease the restriction reflects a continuing shift in the government's posture toward the company and its federally chartered sibling, Freddie Mac of McLean.

When the housing market appeared healthy, many government officials were focused on containing the risks that they feared the two firms' vast mortgage holdings posed to the financial system. Although the government does not explicitly back the two companies, investors generally assume that taxpayers would be called on to bail them out if either became insolvent.

Since the housing bubble burst and other investors have deserted the home loan market, the government has turned to Fannie Mae and Freddie Mac to fill the void. In the process, it has eased a series of constraints on the companies.

"[W]e are being asked to play a broader role in the future of U.S. housing," Mudd said yesterday.

The shift comes as legislation to give regulators more power over Fannie Mae and Freddie Mac remains stalled.

The government's accommodations have been based partly on the two companies' progress in recovering from accounting scandals of years ago.

"The lowering of the prudential cushion was appropriate in line with the company's progress and with the need to maintain safe and sound operations," OFHEO Director James B. Lockhart III said in a statement.

The $2.19 billion of red ink ($2.57 a share) Fannie Mae incurred during the three months ended March 31 contrasted with the $961 million profit (85 cents) it reported in the first quarter of 2007.

Measured in relation to Fannie Mae's overall mortgage guarantees, the company's expenses from foreclosures and other credit problems rose 55.6 percent during the first three months of 2008 compared with the already substantial trouble the company reported in the last quarter of 2007.

One factor was that home prices fell an average of 3 percent in the quarter, faster than the company expected when it was predicting full-year declines of 5 to 7 percent. It said it now expects home prices to fall 7 to 9 percent nationally this year.

Fannie Mae's financial report also showed that it ended the quarter with $9.3 billion of unrealized losses on mortgage investments that it has not yet included in its bottom line, up from $4.8 billion on Dec. 31. Fannie Mae predicts that those securities, most of which have been impaired for a year or more, will recover their lost value.