Shares of Fannie Mae, Freddie Mac Plummet
Report Raises Alarm About Firms' Capital

By David S. Hilzenrath
Washington Post Staff Writer
Tuesday, July 8, 2008

Investors dumped shares of Fannie Mae and Freddie Mac yesterday based on worries that the two pillars of the housing market could be forced to raise $75 billion of capital, potentially confronting them with an overwhelming burden and crippling already struggling financial markets.

Fannie Mae's stock price plunged 16.2 percent, to $15.74, and Freddie Mac's fell 17.9 percent, to $11.91 -- their lowest since 1995.

The sell-off came after a report warning that a proposed change in accounting rules could weaken Fannie Mae and Freddie Mac so severely that it "could possibly topple the already fragile capital markets."

Though it raised the specter of a calamity, the report by Lehman Brothers analyst Bruce W. Harting predicted that accounting rulemakers would make an exception sparing Fannie Mae and Freddie Mac.

"[W]e believe calmer heads will ultimately prevail," Harting wrote.

But an official at the Financial Accounting Standards Board, which sets accounting rules, said a first draft of the board's proposed change would apply to the two companies. The draft underscores that point by including an example that covers their business operations, the official said. The official spoke on condition of anonymity because the document is preliminary and has not yet been released for public comment.

A spokesman for FASB said the proposed change had a long way to go before adoption.

"All of what you're seeing out there right now is extremely speculative," FASB spokesman Neal McGarity said.

At issue are trillions of dollars in mortgage guarantees that Fannie Mae and Freddie Mac made but are not included on their balance sheets as assets or liabilities. FASB's proposed rule would require the companies to move the guarantees to the balance sheets, forcing them to hold additional capital to cover those obligations.

FASB is considering changing the accounting rules in ways that could make it harder for a wide array of companies to keep assets and liabilities off their balance sheets. The rulemaking body wants to make such obligations more visible to investors, the FASB official said.

The general concern over hidden liabilities was brought to the fore earlier this decade by the scandal at Enron. Unlike Enron's extensive liabilities, Fannie Mae and Freddie Mac's mortgage guarantees are detailed in public reports.

Freddie Mac spokeswoman Sharon McHale said the proposed change "could have an effect on our ability to serve the housing market, and we hope that FASB would take into account our mission and our business model in any final decision." Freddie Mac has been discussing the matter with FASB, McHale said.

A spokesman for Fannie Mae declined to comment. A spokeswoman for the Office of Federal Housing Enterprise Oversight, the federal agency that oversees the financial stability of the two companies, also declined to comment.

Fannie Mae, based in the District, and Freddie Mac, headquartered in McLean, help channel money to lenders so they can issue more mortgages. The two companies package mortgages into securities that are sold to investors, promising to make the payments if the borrowers default. They also invest directly in mortgages and mortgage-related securities.

The perception that the government stands behind Fannie Mae and Freddie Mac has helped keep the securities they guarantee marketable at a time when investors have lost their appetite for other mortgage-related securities. Still, the collapse of the housing market has left the companies with rising delinquencies, billions of dollars of losses and stocks that were severely deflated even before the sharp decline yesterday. The Lehman Brothers report rattled investors who were already anxious about the outlook for the housing market in general and the two government-sponsored firms in particular.

Freddie Mac has yet to fulfill a promise made to the government in March to raise new capital; the company recently said it would raise $5.5 billion, partly by issuing more common stock. Its declining stock price could make that more painful by requiring the company to issue a larger number of shares, thereby diluting the investments of current stockholders. The company will not raise the capital until it releases financial results for the quarter ended June 30, McHale said yesterday.

In addition, Freddie Mac has yet to complete the process of registering with the Securities and Exchange Commission, a long-delayed effort that involves an SEC review of its financial disclosures. McHale said the process was "progressing well" but would not say whether the SEC had expressed any significant concerns about Freddie Mac's accounting.

With Freddie Mac's additional $5.5 billion, Fannie Mae and Freddie Mac would together have about $93 billion of core capital, putting them each $13 billion over the current regulatory requirement, Harting of Lehman Brothers said. The proposed accounting change could leave them "significantly undercapitalized" and hard-pressed to raise the needed money -- an estimated $46 billion for Fannie Mae and $29 billion for Freddie Mac, Harting wrote.

Analysts interviewed yesterday said investors' fears about the potential accounting change were overblown.

"I would bet my firstborn that they will be excluded from the accounting change. It would bankrupt them," said Paul Miller of the investment firm Friedman, Billings, Ramsey Group.

"It's a panicked reaction not justified by the facts," said Howard Shapiro, an analyst at the research firm Fox-Pitt Kelton.

Requiring Fannie Mae and Freddie Mac to come up with an additional $75 billion "would mean that our housing market would come to a complete halt, nobody would be able to buy a home, and it would be devastating for the general economy," Shapiro said.

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