Aid to Fannie, Freddie May Top Expectations
Firms' Health Has Worsened During Crisis

By Zachary A. Goldfarb
Washington Post Staff Writer
Friday, November 14, 2008

The first of the Bush administration's major financial takeovers, the seizure of Fannie Mae and Freddie Mac, is poised to get more expensive and some analysts are warning that it may ultimately cost more than the government has suggested.

Mounting troubles in the financial and housing markets have further undermined the health of the companies in the months since the government seized them in September, making it likely the Treasury will be required to pump billions of dollars into the mortgage-finance giants.

Though not a cent has been spent, some analysts are warning the tab could exceed the $200 billion that the government set aside for capital infusions into the two companies.

The first cash injection could come as soon as today, when Freddie Mac is required to report its quarterly earnings.

The prospect of growing assistance underscores how the government is being sucked ever deeper into supporting financial firms with taxpayer money as the worsening financial crisis continues to erode companies that federal officials have vowed are too important to fail.

Under the government's agreement with the companies, the Treasury is required to inject money in any quarter when the companies' liabilities exceed their assets, up to $100 billion for each firm.

When the Treasury seized the firms, it said it had chosen the figures primarily to reassure investors who had been fleeing the companies. "This number is unrelated to the Treasury's analysis of the current financial conditions," the Treasury said at the time, suggesting that there was no expectation the government would spend this amount.

Since then, the financial crisis has deepened, making it even more difficult for the companies to finance their debt, and the economy has been shrinking, stifling the ability of borrowers to make payments on mortgages that are at the heart of the firms' business.

"Depending on what happens with housing, you could see scenarios where the $100 billion comes into the question," said Rajiv Setia, an analyst with Barclays Capital. He said McLean-based Freddie Mac may need $40 billion by the end of the year.

On Monday, District-based Fannie Mae reported a whopping $29 billion loss, bringing it close to triggering a government cash injection. Most of that loss was because the company wrote down the value of tax credits it is unlikely to use.

"If we continue to experience substantial losses in future periods or to the extent that we experience a liquidity crisis that prevents us from accessing the unsecured debt markets," Fannie Mae said in a regulatory filing this week. "This commitment may not be sufficient to keep us in solvent condition."

Many analysts consider Freddie Mac to be in worse financial shape and, if it makes the same decision as Fannie Mae regarding tax credits, would report today that it owes billions more in obligations than it has in assets, triggering a government injection of cash.

In addition to pledging capital, the government has offered the companies an unlimited line of credit.

In return for these backstops, Fannie Mae and Freddie Mac each agreed to give the Treasury $1 billion in preferred stock and pay a $100 million a year as a dividend. The companies' boards also turned over control of the firms to the Federal Housing Finance Agency.

The government's backstops are "well above the worst-case stress test that was run," said FHFA director James B. Lockhart III.

Some analysts are skeptical that the federal backstops were ever enough. Joshua Rosner, an analyst with Graham Fisher, points out that the housing decline underway is the worst since the Great Depression, but Fannie Mae and Freddie Mac have not seen most of the resulting losses. So far, these have not even rivaled what was experienced in the most recent bad real estate slump, in the late 1980s.

"If we saw loss rates at those levels, we would quickly eat through the $200 billion," Rosner said. "This is a once-in-a-century flood."

Fannie Mae said this week that home prices are about halfway through their decline. The firm said prices are down 10 percent from their peak in 2006 and likely to fall as much as 19 percent before stabilizing.

There is no certainty that losses will continue to mount at the firms. If the government's efforts to stimulate the economy succeed and the housing market stabilizes, the companies may require little public money.

"Fannie Mae and Freddie Mac are completely exposed to the housing market," said Howard Shapiro, an analyst at Fox-Pitt Shelton. "Until home values stabilize and delinquency trends stabilize, we're going to continue to have this discussion: What are these losses are going to be?"

Without the government's support for Fannie Mae and Freddie Mac, the financial chaos of the past few months may have brought both firms down, which would have badly exacerbated the global crisis.

Several events have conspired to make their conditions worse, including the economic downturn.

Robert Van Order, a finance professor at the University of Michigan and Freddie Mac's chief economist for 15 years, said many borrowers now owe more on their house than it would be worth if sold. "Most people with negative equity don't give up their house," he said. "It usually requires a trigger event. Unemployment could be one of them."

The companies could also be put in a more difficult position because the government is pushing them to keep buying mortgages in a weakening economy. The goal is for the firms to help push down mortgage rates by flooding the market with money, which should help put a bottom under housing prices. But that may force them to purchase mortgages given to buyers with declining economic prospects, including possible job losses.

"They're going to be insuring or buying mortgages that nobody in the private sector wants," said Peter Schiff, president of Euro Pacific Capital. "The only people who would loan money to Americans right now is the government. Nobody would else do it."

Fannie Mae and Freddie Mac's regulator says they are buying only high-quality mortgages.

Finally, the government itself has taken steps that make it more likely Fannie Mae and Freddie Mac will need its cash. The government has introduced several programs to protect debt issued by other institutions, such as banks. Fannie Mae and Freddie Mac lack this explicit federal guarantee and that has made their debt comparatively less attractive to investors, increasing what the companies have to pay to raise capital in private markets.

As a result, some analysts are concerned that Fannie Mae and Freddie Mac may run out of funding.

"There is a huge and serious liquidity squeeze, and the only way Fannie and Freddie get out of that is by going to the Treasury," said Karen Shaw Petrou, an analyst with Federal Financial Analytics.

Moreover, the decision by Treasury Secretary Henry M. Paulson Jr. to abandon the plan to buy the troubled mortgage-related assets from banks and other financial firms poses a problem for Fannie Mae and Freddie Mac. Not only do the companies lose the chance to sell any of these assets to the government, the announcement Wednesday that the program had been shelved caused the value of the assets to fall.

"You're taking . . . a large buyer out of the market," said Moshe Orenbuch, an analyst at Credit Suisse.

For his part, Paulson said at his news conference that the losses at Fannie Mae this week were in the "range of what we expected and further confirms the need for our strong actions."

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