S&P Puts Fannie and Freddie on Credit Watch Negative

The agency says it could lower the credit ratings of the mortgage lenders as it reviews the risks in the final version of the Housing Reform Bill

On July 25, Standard & Poor's Ratings Services affirmed its 'AAA/A-1+' senior unsecured debt ratings on Fannie Mae (FNM)and Freddie Mac (FRE). At the same time, we placed our 'AA-' risk-to-the-government, subordinated debt, and preferred stock ratings on Freddie Mac, and our 'AA-' subordinated debt and preferred stock ratings and 'A+' risk-to-the-government rating on Fannie Mae on CreditWatch Negative.

"The affirmation of the senior unsecured debt ratings reflects the strong explicit and implicit support these government-sponsored enterprise (GSE) securities hold in the marketplace," said Standard & Poor's credit analyst Victoria Wagner. The most recent public demonstrations of government support by the U.S. Treasury underscore the key public policy role and the key liquidity role the congressional chartered GSEs have in the U.S. mortgage markets. This is reflected in the current stable outlook on the senior unsecured debt.

The U.S. Treasury's three-point liquidity back-stop plan has been added to the pending Housing Reform Bill, HR 3221, which passed a vote in the House on July 23, and is now under review for a vote by the Senate. The weak mortgage credit cycle driving credit losses higher at Fannie Mae and Freddie Mac has led to a crisis of confidence in the strength of their capital positions as the GSEs are facing higher demands for liquidity while their own core mortgage performance is weaker, and there is a higher degree of uncertainty regarding the broader market conditions. This is reflected in the weak pricing of their equity shares during the past few weeks. The broader financial markets remain quite stressed due to the severity and duration of this weak housing and mortgage cycle. Because of this, it looks like HR 3221 will be signed into law within days.

Although there is still ambiguity on the part of regulatory authority as it applies to how nonsenior creditors of Fannie Mae and Freddie Mac would be treated if the U.S. Treasury ever acted on its three-point liquidity plan, the language in HR 3221 increases the likelihood that subordinated debtholders and preferred stockholders would face greater subordination risk. This heightened risk is not incorporated in our current subordinated debt and preferred stock ratings on Fannie Mae and Freddie Mac. We may lower these issue ratings one to two notches at the conclusion of our review of the final legislation. Prior to this we had not incorporated traditional notching of Fannie Mae and Freddie Mac's subordinated debt and preferred stock in relationship to the risk-to-the-government ratings. This is now under consideration, notching the subordinated debt and preferred stock ratings one notch below the risk-to-the-government ratings.

Both firms face weak earnings due to rising credit expenses. The CreditWatch listing on the subordinated debt, preferred stock, and risk-to-the-government ratings underscores the expected higher stress on capital and earnings these firms face during the next several quarters. The confidence crisis in the equity markets is adding to the already stressed business cycle and creates additional challenges in the near term for capital-raising initiatives.

In addition to a detailed review of the final version of the Housing Reform Bill, we will reassess our view of the respective firms' earnings, credit performance, and capital adequacy levels. Currently, both firms operate with a solid capital position above the regulatory minimum capital requirements, but with a lower capital cushion above the regulatory surplus requirement. Fannie Mae raised $7.4 billion of new equity in the second quarter to further bolster its surplus capital position. Freddie Mac's regulatory surplus capital position is currently lower, and it has committed to raise $5.5 billion of capital in the near term.

If we believe that operating losses reach a level that significantly reduces the surplus capital position and further threatens capital-raising efforts to support the respective businesses, we could lower the subordinated debt and preferred stock ratings by one to two notches. The risk-to-the-government ratings on the respective firms could either be affirmed or lowered one notch.

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