Fannie, Freddie Too Critical to Fail, Lawmakers Say (Update5)

By Dawn Kopecki

July 11 (Bloomberg) -- Fannie Mae and Freddie Mac, the largest buyers of U.S. home loans, are too big for the government to allow them to fail, leading Republican and Democratic lawmakers said.

A government takeover of one or both companies is among several options that have been considered by White House officials, according to a person familiar with the discussions who spoke on condition of anonymity. Senior Bush administration officials are considering placing either or both firms in a conservatorship if their problems get worse, the person said.

The companies, which own or guarantee about half of the $12 trillion of U.S. mortgages, can count on a federal lifeline, said Republican Senator John McCain, and Democratic Senator Charles Schumer. Fannie Mae and Freddie Mac would have to post pretax losses and writedowns of about $77 billion before the U.S. would be compelled to start a rescue, according to estimates by Fox-Pitt Kelton and Friedman, Billings, Ramsey & Co.

``They must not fail,'' McCain, of Arizona, said yesterday during a campaign stop in Belleville, Michigan. Fannie Mae and Freddie Mac ``are vital to Americans' ability to own their own homes,'' he said at an earlier stop in the state, one of the worst affected by the surge in foreclosures.

The remarks by the presumptive Republican presidential candidate and Schumer, head of the Joint Economic Committee, indicate Congress would push the administration to use government funds to prevent the companies from failing.

The New York Times earlier today reported the government is considering a takeover of the companies, citing people briefed on the plan whom it didn't name.

`Critical Capital'

Under a 1992 law, the Office of Federal Housing Enterprise Oversight can put Fannie Mae or Freddie Mac into a conservatorship if their ``critical capital'' falls below guidelines. White House and Treasury Department spokespeople didn't immediately return calls seeking comment on whether the administration has considered plans to invoke the authority.

Shares in Washington-based Fannie Mae and McLean, Virginia- based Freddie Mac slid to the lowest levels since 1991 this week on concern the firms don't have enough capital to offset writedowns.

Fannie Mae fell $1.70 to $11.50 in pre-market trading in New York at 7:13 a.m. after sliding 14 percent yesterday, and is down 67 percent this year. Freddie Mac dropped $1.53 to $6.47 after declining 22 percent yesterday and 77 percent this year.

Estimates of Losses

The companies' failure would deepen a housing recession that already is the worst in a quarter century.

``They are adequately capitalized, holding capital well in excess of'' the requirements, James Lockhart, the director of Ofheo, said in a statement yesterday. ``They have large liquidity portfolios, access to the debt market and over $1.5 trillion in unpledged assets.''

Fannie Mae would need to lose $40 billion ``immediately'' and Freddie Mac $37 billion to be considered insolvent, New York-based Fox-Pitt analyst Howard Shapiro said in a report this week. For Fannie Mae, house prices would need to decline 40 percent nationally and delinquency rates would need to rise as much as 10-fold to 12 percent on loans from 2006 and 2007 to reach critical capital levels, Shapiro said.

``We believe this is very unlikely,'' Shapiro said.

Arlington, Virginia-based Friedman Billings analyst Paul Miller estimates losses of about $45 billion and $30 billion before they would fail.

Bondholder Backstop

Congress, which created Fannie Mae during the Great Depression and formed Freddie Mac in 1970, is counting on the companies to help revive the housing market. Congress lifted growth restrictions on the companies, eased their capital requirements and allowed them to buy so-called jumbo mortgages to spur demand for home loans as competitors fled the market.

Central banks, pension funds and other investors hold $5.2 trillion in debt sold by the companies, exceeding the $4.6 trillion in Treasury notes. Foreign holdings of Fannie Mae, Freddie Mac and other so-called agency debt rose a net $15.3 billion in April, the latest Treasury data on Bloomberg show.

Fannie Mae and Freddie Mac raised a combined $20 billion since December to cover losses of more than $11 billion generated since the credit crisis began last year. Freddie Mac has yet to raise a planned $5.5 billion, scheduled for mid-year.

While bondholders can count on a backstop, equity investors can't expect the government to halt a tumble in the companies' shares, Representative Spencer Bachus, the senior Republican on the House Financial Services Committee, said yesterday.

Short Sellers

Some 82.8 million shares of Freddie Mac were sold ``short'' as of the end of June, the most since at least 1991, according to New York Stock Exchange data compiled by Bloomberg. In a short sale, an investor sells borrowed shares in the hope of profiting by buying them back later at a lower price.

Short interest in Fannie Mae increased to 140.4 million shares as of the middle of last month, the highest since at least 1991, before falling to 138.7 million at the end of June, NYSE data show.

Stockholders should be prepared for more ``difficulties,'' said Kevin Flanagan, a fixed-income strategist in Purchase, New York, for Morgan Stanley's individual investor clients. ``Continued woes, continued difficulties are the expectation, and this is going to take a while to play itself out,'' he said.

Fair Value

Freddie Mac owed $5.2 billion more than its assets were worth in the first quarter, making it insolvent under fair-value accounting rules. The fair value of Fannie Mae assets fell 66 percent to $12.2 billion, data provided by the Washington-based company show, and may be negative next quarter, former St. Louis Federal Reserve President William Poole said.

``Markets should be assured that the federal government will stand by Fannie Mae and Freddie Mac,'' Schumer, of New York, said in a statement yesterday. They ``are too important to go under,'' and Congress ``will act quickly'' if necessary, he said.

Fed Chairman Ben S. Bernanke and Treasury Secretary Henry Paulson, while noting the central role of Fannie Mae and Freddie Mac in ending the mortgage-finance crisis, refrained yesterday from endorsing any extra federal backing for the companies.

The firms ``are playing a very important and vital role right now,'' Paulson said in testimony to the House Financial Services Committee. They ``need to continue to play an important role in the future,'' he said.

`Expand' Capital

Fannie Mae and Freddie Mac ``are well capitalized now'' in ``a regulatory sense,'' Bernanke told the panel. Still, the companies, like all financial institutions, need ``to expand their capital bases,'' the Fed chief said.

The federal government can't afford to take over all of Fannie Mae's and Freddie Mac's operations, because such a move would more than double federal government debt outstanding and ``have disastrous consequences for the dollar,'' said Joshua Rosner, an analyst with Graham Fisher & Co. Inc. in New York.

Instead, the government could move the companies' combined $1.5 trillion investment portfolios into a separate limited liability corporation that would gradually liquidate the assets, Rosner said. Fannie Mae and Freddie Mac would still be able to support the U.S. housing market by packaging home loans into securities they guarantee.

The Treasury, which analysts said would play a central role in any rescue of the firms, currently has the authority to buy $2.25 billion in each of the companies' debt.

Treasuries fell the most in three weeks, increasing the yield on the benchmark two-year note by 8 basis points to 2.49 percent, according to bond broker BGCantor Market Data.

`Dangerous Waters'

While a federal rescue is ``premature,'' Representative Paul Kanjorski said lawmakers and officials should prepare for more trouble.

``I don't think any of us could anticipate all the contingencies that can happen,'' said Kanjorski, a Democrat from Pennsylvania. ``We recognize that we're in very dangerous waters, very stormy. We should have contingencies.''

A taxpayer-funded rescue shouldn't be an option, said Representative Jeb Hensarling, chairman of the fiscally conservative Republican Study Committee.

``The government should not be supporting the system as is,'' said Hensarling, of Texas. Fannie Mae and Freddie Mac ``no longer helps the market in the way that it once did'' while posing ``a huge systemic risk'' to the economy, he said.

In a sign that bondholder confidence is more stable, the difference in yields between Fannie Mae's 10-year notes and 10- year U.S. Treasuries narrowed by 2.2 basis points yesterday from a four-month high of 89.9 basis points July 7. Freddie Mac's yield premium diminished 2 basis points, from a four-month high of 96 basis points this week.

To contact the reporter on this story: Dawn Kopecki in Washington at dkopecki@bloomberg.net

Last Updated: July 11, 2008 07:19 EDT

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