Fannie, Freddie On a Tightrope
Mortgage Giants Navigate Market Volatility, Unique Role

By Jeffrey H. Birnbaum and Christopher Twarowski
Washington Post Staff Writers
Tuesday, July 29, 2008

The collapse in the stock prices of Fannie Mae and Freddie Mac earlier this month, followed by an equally dramatic rebound, underscored the vulnerability of today's agitated markets to panic and the mercurial behavior of global traders.

Financial experts said the drop, nearly 50 percent in a week, was precipitated by a series of alarming reports from analysts and in the media and was then turbocharged by a surge in short selling, bets made by investors that the shares would fall.

The federal government's response -- an unprecedented Treasury rescue plan approved by Congress this weekend, along with a move by the Securities and Exchange Commission to stop an especially troublesome type of short selling -- prompted a surge in the stock prices.

But the actions did not solve fundamental problems still facing the mortgage finance giants, especially their low levels of capital relative to those of other financial firms. The companies' leaders acknowledge that the rescue plan alone will not end the stock volatility or ease concerns about whether Fannie Mae and Freddie Mac have the resources to weather the financial crisis in coming months.

"I don't think it will end the debate," Richard F. Syron, chief executive of Freddie Mac, said in an interview last week.

The precise balance between their public duties as government-chartered companies and obligations as investor-owned enterprises remains disputed.

Like other financial firms, Fannie Mae and Freddie Mac are under pressure to boost their capital reserves to compensate for mounting losses in the mortgage market. But if they do, they would have less money for their unique mission of supporting home lending across the country at a time when other lenders are fleeing the market.

"There's a lot of vulnerability out there, and we need to remain vigilant," Fannie Mae chief executive Daniel H. Mudd told CNBC earlier this month. "There is a lot of work to do."

Critics of Fannie Mae and Freddie Mac have fought in Congress for a decade to force the companies to build up their capital, fearing a calamity in the financial markets if the mammoth companies falter. These appeals went largely unheeded until late last year, in part because of the companies' potent lobbying efforts. Fannie Mae fulfilled a promise to regulators to raise more capital this year; Freddie Mac has not yet done so.

With housing prices falling and foreclosures skyrocketing, Fannie Mae and Freddie Mac have suffered combined losses of $11 billion in the past three quarters. The companies, which guarantee mortgages, have been forced to pay off the holders of mortgage-backed securities when homeowners were no longer able to make their loan payments. The pair have also had to write off the value of mortgages they hold on their own books as housing prices fell.

Wall Street's fears about the companies were magnified by the jumpiness of the markets in general, especially about financial stocks being battered by a worldwide credit shortage.

The worries came to a head July 7, when the investment bank Lehman Brothers reported that a proposed change in accounting rules might force Fannie Mae to raise $46 billion in capital and that Freddie Mac might have to add $29 billion. The companies' stock was pummeled. Three days later, William Poole, a former president of the St. Louis branch of the Federal Reserve, publicly called the companies "insolvent" and said the housing markets' woes increased chances that the United States would have to bail them out.

With major newspapers publishing front-page reports about the mounting peril facing the companies, including a possible government takeover, investors ran for the door. On July 11 alone, more than 400 million shares of Fannie Mae changed hands -- 20 times as much volume than on a typical day at the end of June -- and its price fell by 22 percent.

"There was panic-dumping going on," said Samuel Lieber, president of Alpine Mutual Funds. "The classic extremes of Wall Street came into play: fear and greed."

The downward spiral was exacerbated by the large number of investors who bet on the stocks' decline and sold the stocks short. The number of Freddie Mac shares sold short had nearly doubled from March 31 to June 30, to 82.8 million. For Fannie Mae, the number of short sales more than doubled, to 138.7 million from 63.1 million, over the same period.

Then, from June 30 to July 15, short sales of Freddie Mac rose 28 percent and increased 11 percent for Fannie Mae, according to Bloomberg News.

"We became a very popular, almost can't-lose, short," Syron said.

Wall Street insiders called the sell-off a classic panic. Syron said the selling binge was "fear- and emotion-driven" and occurred even though "the fundamental economics of both companies I don't think was a lot different than it was a month ago."

Worried that the stock slide could cripple the companies and undermine markets around the world, Treasury Secretary Henry M. Paulson Jr. went into emergency mode. To prevent further erosion, the Treasury, the Federal Reserve and company officials worked through the weekend of July 12 and 13 to devise a rescue plan. It made more explicit what had been only implicit before: that the U.S. government would stand behind Fannie Mae and Freddie Mac. The government offered new loans and outright purchases of their stock if needed.

The SEC also made it harder for investors to undermine Fannie Mae's and Freddie Mac's stocks by tightening the rules governing short sales. The order was temporary. The SEC is scheduled to announce today whether it will extend it and, if so, for how long.

The SEC's order in particular caused what analysts call a "short squeeze" among Fannie Mae and Freddie Mac short sellers, said Art Hogan, chief market analyst at Jefferies & Co. A short squeeze pushes the price of a stock higher as short sellers liquidate and repurchase stock to cover their positions. The amount of short selling in Fannie Mae and Freddie Mac plummeted by 90 percent from July 14 to July 21 due to the SEC's emergency order, according to an analysis of market statistics by S3 Matching Technologies.

By July 18, the stocks had nearly doubled from their lows, hit earlier that week.

But last week, the companies' shares slumped again -- though less severely, with Fannie Mae down 13.8 percent and Freddie Mac 9.9 percent -- after existing-home sales reached their lowest level in a decade and investor Bill Gross of Pimco predicted that the housing slump could cost firms $1 trillion. Yesterday, Fannie Mae shares fell 10.7 percent and Freddie Mac dropped 6.7 percent.

"We are in a period of very high volatility for them," said Deborah Lucas, a finance professor at Northwestern University. "It's off the charts."

The companies have long been popular overseas investments, especially in Asia, where the Treasury plan has helped to calm nerves. Deborah Schuler, a senior vice president for Moody's, said the threat to Asian banks and insurers from the problems facing Fannie Mae and Freddie Mac are limited. "The U.S. government has made it very clear they back Fannie and Freddie, and so there shouldn't be a need to sell them," she said.

Sunil Garg, head of equity research for Asia at J.P. Morgan Chase, said he also does not believe that any Chinese, Japanese or other Asian holders of Fannie Mae and Freddie Mac securities are selling.

At the same time, the recent difficulties at the companies have helped send U.S. mortgage rates to their highest levels in a year. And those troubles could get worse. On Friday, the credit-rating firm Standard & Poor's said it might downgrade its ratings on some of the companies' bonds because of difficult market conditions, potentially increasing their borrowing costs.

Financial experts said the abrupt decline in the companies' stock prices earlier this month had not been unexpected.

"This was like a ticking time bomb that just happened to have gone off right now," said Desmond Lachman, a scholar at the American Enterprise Institute. The reason, he said: "They were operating at incredibly low capital ratios."

Syron said the government's decades-old goal of assuring that long-term mortgages are available to the public at reasonable prices could be accomplished only by firms that are "highly leveraged" and operate on a thin cushion of capital. He added that the dramatic swing in his firm's stock was "inherent in the system in which you have very highly volatile markets."

But some financial analysts attributed the fall in the stock prices to the finances of Fannie Mae and Freddie Mac.

"What surprised me at the time was that it hadn't collapsed earlier," Lucas said.

Special correspondent Ariana Eunjung Cha in Shanghai and staff writer Dina ElBoghdady in Washington contributed to this report.

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