Sept. 22 (Bloomberg) -- Freddie Mac Chief Executive Officer Richard Syron stood before investors at New York's Palace Hotel in May last year lauding his company's ``cautious'' avoidance of the subprime-mortgage crisis.

What Syron, who was ousted last week, didn't say was that Freddie Mac had been gorging on subprime and Alt-A debt. While it and the larger Fannie Mae bought the safest classes of the mortgage-loan pools, Freddie's purchases totaled $158 billion, or 13 percent, of all the securities created in 2006 and 2007, according to data from its regulator and Inside MBS & ABS, a Bethesda, Maryland-based newsletter used by Federal Reserve researchers. Fannie, which was also seized by the U.S. on Sept. 7, bought an additional 5 percent.

The purchases by Freddie and Fannie helped fuel the boom in lending that led to frozen credit markets, more than $514 billion in bank losses and the collapse of two of the country's biggest securities firms. The subprime overhang may determine whether the $200 billion U.S. Treasury Secretary Henry Paulson earmarked for the companies will all be used to rev up mortgage lending. He may have to spend about $300 billion, William Poole, the former Federal Reserve Bank of St. Louis president, said in a Bloomberg Television interview this month.

`Losses Accumulate'

The final sum ``is going to depend on how fast these losses accumulate,'' said Poole, 71. The deficit may grow quickly because the companies may be ``carrying some of these assets at prices above where they should be.'' Treasury spokeswoman Jennifer Zuccarelli declined to comment. The department's capital injections will keep the companies from defaulting on their almost $6 trillion of debt and mortgage-backed securities.

Fannie's 5-year debt yields traded at 0.78 percentage point above 5-year U.S. Treasuries at 4 p.m. New York time, compared with 0.94 before the bailout, according to data complied by Bloomberg.

Fannie Mae of Washington and McLean, Virginia-based Freddie Mac held $114 billion of subprime and $71 billion in Alt-A securities as of June 30, according to the companies. Subprime mortgages were given to people with poor credit scores. Alt-A loans, which rank between subprime and prime, were made to borrowers with better credit who provided no proof of income, bought property for investment or took out so-called option adjustable-rate mortgages.

`Big Players'

``We've heard a lot of people stand up and say, `Fannie and Freddie really did not promulgate the problems; they weren't big players,''' said Joshua Rosner, an analyst with Graham Fisher & Co., an independent research firm in New York. ``Actually, they were.''

The biggest suppliers of the securities to Fannie and Freddie included Countrywide Financial Corp. of Calabasas, California, as well as Irvine-California-based New Century Financial Corp. and Ameriquest Mortgage Co., lenders that either went bankrupt or were forced to sell themselves. Fannie and Freddie were the biggest buyers of loans from Countrywide, according to the company.

Fannie and Freddie, which were taken over by the Treasury and the Federal Housing Finance Agency, the new regulator created for the companies last month, reported writedowns of less than $2.9 billion on those securities. Their actual value had declined by $40 billion more as of June 30, though the losses were deemed temporary, according to the companies. They've probably dropped at least an additional $5 billion in value since, according to Moshe Orenbuch, an analyst at Credit Suisse in New York.

`Sizable Losses'

``I'm sure there will be some sizable losses,'' Orenbuch said.

The companies said actual losses on the securities aren't likely to be that large.

Freddie won't lose anything on about 95 percent of its uninsured subprime bonds unless more than 90 percent of borrowers already two months late are foreclosed upon and more than half of the rest default, according to slides from a company presentation in August.

Fannie and Freddie also guaranteed from $470 billion to $873 billion of debt backed by borrowers with credit scores below 700 out of a possible 850, less than 20 percent of the starting equity in their homes, or both, according to calculations by FTN Financial based on public disclosures about their mortgage securities.

The companies face losses on those and other guarantees, Rosner said. FTN, the securities arm of First Horizon National Corp. in Memphis, Tennessee, has underwritten Fannie and Freddie debt sales.

40 Percent

The two companies, created to increase home ownership and provide market stability in times of turmoil, own or guarantee more than 40 percent of U.S. residential mortgages.

They make money by buying both home-loans and mortgage- backed securities, funding their purchases with low-cost debt. They also guarantee home-loan securities, putting their AAA rating behind the debt to attract investors. The firms mainly buy debt guaranteed by each other and U.S. agency Ginnie Mae, known as agency mortgage securities.

The companies said they were urged to increase purchases of subprime debt by the Bush administration. The Department of Housing and Urban Development said in 2005 that Fannie and Freddie should increase financing for low-income areas or moderate-income regions with high minority populations to 37 percent of new business from 34 percent in 2001 through 2004. That rose to 39 percent last year.

The updated goals ``were significant enough to force them to go down the credit curve to meet them, which meant participating in some way or form in the higher-risk areas of the mortgage market,'' said David Stevens, a former head of Freddie's single- family mortgage business who now runs lenders affiliated with Long & Foster Real Estate Inc. in Fairfax, Virginia. That included ``the subprime business.''

Shareholder Pressure

At the same time, Fannie and Freddie were under pressure from shareholders to generate profits to bolster their stock price. Fannie dropped 17 percent from 2004 through 2006 and Freddie declined 7.9 percent. The Standard & Poor's 500 Index, by contrast, gained 7.4 percent.

Fannie and Freddie gravitated to the securities as yields on agency mortgage bonds often fell below the cost of selling their debt. In 2006, AAA rated securities backed by subprime or second mortgages averaged 0.57 percentage points more than U.S. Treasuries, according to Lehman Brothers Holdings Inc. index data. That compares with 0.48 percentage points for fixed-rate agency mortgage securities.

The public and private demands on Fannie and Freddie led to their demise, Paulson said on Sept. 7, when he announced the government was assuming control after their shares plunged more than 90 percent. HUD said the companies shouldn't blame policy makers for driving up subprime holdings. The companies weren't required to keep the debt on their books as part of their home- financing goals.

Securities, Not Loans

``If Freddie Mac and Fannie Mae are holding securities backed by these loans, it is because they were attracted to their yields and not because of a public policy designed to promote affordable homeownership,'' HUD said in a statement on its Web site. Spokesman Brian Sullivan declined to elaborate.

As they acquired subprime debt, Fannie and Freddie fed on mortgage-backed securities, rather than buying or guaranteeing individual loans, according to Judy Kennedy, chief executive officer of the National Association of Affordable Housing Lenders in Washington.

`Hundreds of Billions'

The companies could have bought ``hundreds of billions of dollars'' of loans made to low-income people by banks, some of which were granted with terms that were equal to prime, said Kennedy, whose organization represents financial companies including JPMorgan Chase & Co. of New York, Charlotte, North Carolina-based Bank of America Corp. and pension funds. Fannie and Freddie failed to buy $50 billion to $90 billion of apartment-building loans that would also have qualified, she said.

The bonds Fannie and Freddie bought comprised thousands of loans to borrowers with poor credit. The securities are split into pieces with varying risk and returns. Fannie and Freddie bought the safest of the top-rated pieces of the securities. Their yields of about 0.1 percentage points above the London interbank offered rate made the debt less appealing to other investors, such as hedge funds or collateralized debt obligations, whose safest pieces were bought by banks. The lowest investment-grade classes offered yields of about 1.95 percent points over Libor.

Willing to Buy

The companies' willingness to buy the low-yielding pieces provided demand that fueled subprime lending, Kennedy said.

``Their throwing of money at subprime has boomeranged,'' Kennedy said.

The companies can't be blamed for fueling the crisis, said Thomas Lawler, a former senior vice president for risk policy at Fannie who left in January 2006 after 22 years. Other investors would have bought the same securities and demanded a yield increase of less than 0.1 percentage points, said Lawler, an economist in Vienna, Virginia.

``People say, `You may not have been keeping it alive, but you should have been doing everything you can to kill it, and you certainly weren't doing that. If anything, you probably helped it along a little bit,''' Lawler said. ``I do think there is validity to that.''

Former Fannie Mae CEO Dan Mudd, 50, said in a 2006 interview that he planned to expand the companies' holdings to include more higher-risk loans. Anything else would be ``counterproductive,'' he told investors in March of that year. Brian Faith, a spokesman for Fannie, declined to comment.

Prove Their Worth

Syron, 64, said at the investor conference in May 2007 that the subprime collapse let Fannie and Freddie prove their worth by offering refinancing options to some borrowers whose rates were set to rise and remaining active in the mortgage market as others fled.

``In the current period, I have to say I am sort of grateful that we have been cautious for a variety of reasons,'' Syron said. Sharon McHale, a spokeswoman for Freddie, declined to comment, as did Stefanie Mullin, a spokeswoman for the companies' regulator.

Demand from Fannie and Freddie was large enough that the nation's biggest issuers created securities tailored to meet the mortgage giants' needs, according to prospectuses for the bonds.

New Century, which collapsed into bankruptcy after being overwhelmed by customer defaults and an accounting fraud, and Ameriquest, once the biggest home-loan provider to consumers with poor credit, produced securities backed by loans small enough for Fannie and Freddie to buy. Fannie and Freddie's government charter restricted them from buying loans of more than $417,500.

Limiting Penalties

The bonds also met other criteria demanded by Fannie and Freddie. They included limiting penalties to homeowners who pay off early and banning contracts that force borrower complaints into arbitration instead of courts.

Ameriquest paid $295 million to consumers in 2006 to settle charges by states of predatory lending.

The company, which sold part of itself to Citigroup Inc., created 52 percent of its securities for Fannie and Freddie in 2006, according to newsletter Inside B&C Lending.

New Century, now the biggest subprime lender in bankruptcy, produced 24 percent. It created a security for Fannie and Freddie in August 2006. About 75 percent of the loans had interest rates set to adjust to as high as 20 percent, mostly after two years, from an average of 8.3 percent.

Countrywide, which faces investigations for fraudulent lending practices, supplied about 23 percent of Fannie's and Freddie's total loan volume in 2007, according to Credit Suisse.

Terry Francisco, a spokesman for Bank of America Corp., which bought Countrywide for $2.5 billion in stock in July, declined to comment.

`Affordability Programs'

The lender's chief risk officer, John McMurray, told analysts in a conference call in July last year that Fannie would buy loans to borrowers with credit scores from Minneapolis-based Fair Isaac Co., known as FICOs, that would typically be considered subprime. Fannie used those loans to meet its affordable-housing goals, McMurray said.

``There is a belief by many that prime FICOs stop at 620,'' McMurray said. ``That's not the case. There are affordability programs and Fannie Mae expanded approval, as an example, that go far below 620, yet those are still considered prime.''

Borrowers were at least 60 days late on about 31 percent of the loans underlying Freddie's $81.6 billion of uninsured subprime securities, including almost 37 percent of the ones underlying the company's $33.1 billion of remaining 2006 securities, according to an earnings presentation in August.

To contact the reporter on this story: Jody Shenn in New York at jshenn@bloomberg.net.

Last Updated: September 22, 2008 16:42 EDT