Freddie Mac's Next Hurdle: Raise Cash

Unlike the situation facing Bear Stearns earlier this year, Fannie Mae and Freddie Mac are not short of cash. (By Chris Hondros -- Getty Images)

Moreover, at a time when commercial banks have become cautious about new loans, Fannie Mae and Freddie Mac continue to provide liquidity for more than 70 percent of new home mortgages.

In addition, banks, pension funds and other institutions as well as foreign governments hold large amounts of the two firms' bonds. Any suggestion that the U.S. government wasn't standing behind the firms might cause widespread losses and further caution in credit markets.

"We have no options like we did with S&Ls. These two are so large and so vital to the continued operation of the mortgage markets that the government must back them," said Peter Wallison, a longtime critic of implicit government backing for the firms and general counsel of the Treasury under President Reagan. "We should be grateful that they still have sufficient capital to be considered by their regulator to be viable and that capital markets see Fannie and Freddie as backed by the government."

Many economists, citing the U.S. thrift and Japanese banking crises, are urging the Bush administration to seize this troubled moment to try to change the nature of Fannie Mae and Freddie Mac or gradually shrink their size to reduce the economy's exposure to them. These economists warn that U.S. government efforts to prop up S&Ls and Japanese efforts to prop up big banks years ago only extended and increased the size of those financial debacles.

From the mid-1980s to mid-1990s, the U.S. government seized more than 1,000 thrift institutions and sold off more than $500 billion in assets at a taxpayer loss of $124 billion. The size of those assets would be equal to approximately $830 billion today and the taxpayer loss about $165 billion. In Japan, the government gave "regulatory forbearance" to insolvent banks, which deteriorated even further before more painful measures were taken.

At the same time, economists and financial analysts caution against hasty measures. The past week created a sense of urgency as Fannie Mae shares plunged 45 percent for the week to barely a seventh of its 52-week high and Freddie Mac shares sank 47 percent for the week to one-ninth of its 52-week high. Based on the recent disclosure statements, investors in big mutual funds managed by Capital Research Global Investors, Fidelity Investments, Legg Mason and American Funds have suffered heavy losses. Fannie Mae and Freddie Mac have lost more than $100 billion of market value in the past year.

But unlike Bear Stearns, the two mortgage firms do not have a liquidity or cash crisis. There has been no run on the bank like the one that put Bear Stearns at the mercy of the Fed. The gap between Fannie Mae bonds and Treasury bonds actually narrowed Friday, a vote of confidence on the part of people willing to provide money for the firm to buy more mortgages from banks.

More worrisome is the sharp rise in delinquent home mortgages held or guaranteed by Fannie Mae and Freddie Mac, and that will result in some losses. But the quality of the big bundles of residential mortgages is far better than the commercial loans at many of the S&Ls or Japanese banks that failed during the earlier financial crises. At one point, the bad loans on the books of Japanese banks totaled more than a quarter of the Japanese economy, said Adam Posen, deputy director of the Institute of International Economics. Although Fannie Mae and Freddie Mac loans total 45 percent of the U.S. economy, a relatively small percentage of those are bad and the quality of new loans is probably better than the old ones now that lenders are more cautious.

Citigroup analyst Bradley Ball issued a "flash" report Friday urging regulators at the Office of Federal Housing Enterprise Oversight "to step up and express its support for management, reminding investors that the GSEs [government sponsored enterprises] continue to perform their mission and are adding less risky new business with solid margins."

If a rescue were needed, its cost would depend on the strategy used.

Much of the stock market's anxiety about the firms is linked to the regulatory requirement that the firms revise the estimated market value of the $5.2 trillion of mortgages they own or guarantee to reflect likely defaults by homeowners. On paper, this has led to big losses. Because no one knows how many homeowners will be delinquent on loans, it isn't clear whether Fannie Mae and Freddie Mac will do better -- or worse -- than expected.

Freddie Mac is planning to raise $5.5 billion by selling a combination of common and preferred stock and may suspend part of its dividend, analysts said. Many financial experts say the current market value of those mortgage bundles is lower than it should be.