A Dec. 5 Washington Business story on Fannie Mae and Freddie Mac incorrectly stated that the companies had to remove a combined $16 billion in profit from their books. It should have said they had to restate a combined $16 billion in profit. Fannie Mae had to erase $10.8 billion in profit, while Freddie Mac added $5 billion in profit. As a result, Freddie Mac did not have to reduce its portfolio holdings to meet capital requirements, as stated in the article. (Published 12/6/2005)

Struggling through the aftermath of multibillion-dollar accounting scandals, officials at Fannie Mae and Freddie Mac say their most difficult decisions may lie ahead. With stiffer competition from other companies and the changing tastes of home buyers in the types of loans they want, the companies face a choice between moving into riskier types of investing and acknowledging to stockholders that their potential for growth is limited.

In either case, company officials say, the business model that has generated record profit in recent years -- buying standard 30-year mortgages from banks so bankers would have more money to lend -- must change.

"Where in the olden days, you had a choice of selling your mortgage to Fannie Mae or Freddie Mac, in the future, there are lots of alternatives," a fact that has prompted a search for ways to diversify, Fannie Mae chief executive Daniel H. Mudd said in a recent interview.

The companies' options include becoming more deeply involved in the adjustable-rate mortgages that many consumers have preferred in recent years, financing more multifamily developments, and changing the standards for granting mortgages to take more risks with consumers who have spotty credit records.

The companies are even concerned about sustaining their staple business -- bundling mortgages into securities that are sold to investors throughout the world -- now that large institutions such as Countrywide Home Loans Inc., Lehman Brothers Inc. and Bear Stearns & Co. have moved into it. Fannie Mae and Freddie Mac's share of the mortgage-backed-securities business has fallen from more than 60 percent in 2000 to around 40 percent this year, according to the trade publication Inside Mortgage Finance.

District-based Fannie Mae and McLean-based Freddie Mac are two of the area's largest and most visible businesses, employing more than 8,000 in the region.

"The challenge for us is to reassert our presence in those areas where we've lost a bit of competitive advantage," said Patricia L. Cook, Freddie Mac's executive vice president for investment and capital markets.

The companies have not faced such fundamental questions about their underlying business model since the 1980s, when the collapse of the savings and loan industry under billions of dollars in bad debt pushed Fannie Mae into the red.

The current dilemma, in contrast, follows an era of explosive earnings growth at both firms, which helped turn a pair of bread-and-butter, government-chartered mortgage finance companies into high-performing growth stocks and prompted Fannie Mae chief executive Franklin D. Raines to promise Wall Street similar results far into the future. The companies' earnings, it was later disclosed, were inflated through accounting techniques that masked some investment losses.

Top executives, including Raines, were forced out, and the companies had to remove a combined $16 billion in profit from their books. Freddie Mac officials say they are nearing the point where they can produce reliable financial results. Fannie Mae is further behind and remains the subject of several federal investigations.

As they emerge from those crises, executives say part of their post-scandal life is to set more realistic expectations. Fannie Mae's stock is down about 30 percent this year, closing Friday at $47.99 a share. Freddie Mac's share price is off by slightly over 7 percent for the year and ended the week at $62.90.

"We've transitioned from growth to a value stock," Cook said. "The investment and analyst community appropriately expects us to be getting back to business."

The companies are also trying to cope with a mortgage industry much freer in its lending and much more likely to hold mortgages in-house for longer periods and with consumers more willing to take on riskier, adjustable-rate loans to keep their monthly payments down.

Fannie Mae, founded during the Great Depression to keep the home mortgage market liquid, and Freddie Mac, chartered in 1970 to compete, built their businesses around the fixed-rate, 30-year mortgage and a more conservative banking climate. Their presence, as a source of cash and a standard-setter for how to rate mortgage applicants, encouraged banks to lend money. Lenders could initiate loans and pocket the fees, confident that as long as the borrower met Fannie Mae's or Freddie Mac's standards, they could resell the loans to one of them, get their capital back, and make another loan.

The companies tended to shy away from delving too deeply into adjustable-rate and other unconventional mortgages, regarding them as too risky. Such loans, however, have soared in popularity and now account for more than 30 percent of U.S. home mortgages issued in 2004, said Dale Westhoff, Bear Stearns's senior managing director of mortgage research.

In contrast, loans that conform to Fannie Mae and Freddie Mac's basic guidelines -- the companies cannot, for example, accept loans of more than $417,000 because their basic mission is to support middle- and low-income housing -- have fallen from more than 62 percent of loans issued in 2003 to less than 36 percent of loans issued this year, according to Inside Mortgage Finance.

"So much of the new mortgages don't fit into their framework," said William C. Apgar Jr., a former assistant housing and urban development secretary now with Harvard University's Joint Center for Housing Studies. "Fannie and Freddie did a big service taking a relatively unorganized system and saying, 'If you present a mortgage of this type, we can bundle them together and sell them to investors.' Now the flow of product is so much more complex and requires so much information," he said.

"Fannie and Freddie haven't figured out a way to get into that segment of the market," Apgar said. "They're constrained because of their concern about how well they can manage that risk."

Demand for adjustable-rate mortgages has begun to taper off lately as interest rates have risen. But housing finance experts say adjustable-rate mortgages are here to stay.

"It's unlikely Fannie Mae and Freddie Mac will ever see the market shares they saw in the early 2000s," Westhoff said. "We will continue to see a higher share of adjustable-rate mortgages than we've seen historically."

Fannie Mae and Freddie Mac are not willing to let the market pass them by. Executives of both companies argued that they will have to adapt to fulfill their government-chartered mission to keep money flowing into the housing market.

"As we look at our business, we realize we have a special role to fulfill in the market," Mudd said. "Various strategies we may consider clearly need to be examined in terms of our mission to support the market and help low- and middle-income families." Mudd said that after the firm puts its accounting problems behind it, it will "participate in more markets with more products . . . and more flexible products for people with a credit blemish on their record and for first-time minority home buyers."

Freddie Mac already has stepped up its investment in adjustable-rate mortgages, although about 80 percent of its holdings still are long-term, fixed-rate loans.

As the firms look for new ways to grow, both will have to be careful not to grow too much. Their investment portfolios, which grew rapidly in the 1990s, were a major source of the accounting violations at both companies. Congress is considering legislation that would give a new regulator for Fannie Mae and Freddie Mac varying levels of authority to scale back the size of their holdings. A Senate proposal would limit the kinds of assets they can hold.

Fannie Mae and Freddie Mac have already been forced to become smaller to satisfy regulatory requirements, shedding a combined $200 billion in portfolio holdings.

"The market is so competitive that even if our favored and friendliest customer sees us as being off by a [tenth of a] point, they're going to sell the business to somewhere else," Mudd said. "We've got to build the company to manage that and be ready for it."

Daniel H. Mudd, Fannie Mae's chief executive, acknowledges that the company must change the way it does business.