Can Fannie and Freddie fix the mortgage crisis?

Rudyard Kipling, the poet of Britain's high imperial age, once wrote of the hypocrisy of a country that often spurned its soldiers, or Tommies, in times of peace and then embraced them when there was a war to fight and win. He said:

"Oh, it's Tommy this, an' Tommy that, an' Tommy go away; But it's 'Thank you Mr Atkins,' when the band begins to play"

Management at the two government-sponsored enterprises Fannie Mae and Freddie Mac might sympathise with Kipling's soldiers. After years in the wilderness, reviled by legislators and regulators, their role in the capital markets reduced to a shadow of their former glory, the GSEs have now been rehabilitated and restored.

"All of a sudden, they're the most popular guys in Washington DC," says Carl Lantz, interest rate strategist at Credit Suisse in New York.

On February 27, the Office of Federal Housing Enterprise Oversight, the GSE regulator, lifted an investment cap which limited the amount of loans and investments Fannie Mae and Freddie Mac could hold. Three weeks later, on March 19, Ofheo also said that it would begin to ease by a third the requirement that the two GSEs hold an extra capital cushion of 30% beyond legal limits - the so-called 'surcharge' - in an initiative that was claimed would provide an extra $200 billion of liquidity to the mortgage market.

These strictures had been imposed in 2004 and 2005 following accounting indiscretions involving derivatives at both institutions. In 2003, Freddie Mac revealed it had understated earnings by $5 billion, which resulted in a $125 million fine and a comprehensive management shake-up.

A year later, Fannie Mae was heavily censured in a report by the regulator for what was termed a "corporate culture that emphasised stable earnings at the expense of accurate financial disclosures". In 2006, civil suits were filed against three senior management members.

In the firing line

These revelations occasioned much outraged comment at the time, particularly from Republican lawmakers who had always felt the GSEs were a blot on the free market landscape. "Investors have been fooled, homebuyers have been cheated and taxpayers are at risk," said Rep Richard Baker (R-La), chairman of the House capital markets subcommittee.

Greater regulation was called for, and, with capital restraints in place, it seemed Fannie and Freddie would never play such a significant role in the nation's debt markets again. But then subprime happened, and US regulators felt they needed to recruit even the formerly disgraced to the cause.

Ofheo declared in February that the investment cap was being lifted because the two companies had begun to file timely reports once again. But this hardly seems credible. In the week of this announcement Freddie divulged a fourth-quarter loss of $2.5 billion and a yearly loss of $3.1 billion while Fannie showed an annual loss of $2.1 billion. This hardly seems a sure foundation on which to build greater debt-raising capacity.

Of course, the real reason for the relaxation of these rules is that the US housing market is in the grip of an unprecedented crisis and the authorities are turning to anybody and everybody for help. By these measures, US regulators hope to introduce greater liquidity to the wholesale mortgage market and possibly arrest the downward spiral of house prices.

Only six months ago federal regulators blocked efforts by Fannie and Freddie to expand their holdings of mortgages. In a letter to Congress last September Fed chairman Ben Bernanke said that a relaxation of mortgage portfolio restrictions would be "ill advised". Clearly things have got a lot worse since then.

"Ofheo in general has wanted to have stiff requirements, but with the crisis in the mortgage market the administration has had to do something," said an analyst in New York that has followed these events closely. "There has been a lot of political pressure to help out the mortgage market."

The move is not without its risks. Fannie Mae and Freddie Mac are being encouraged to diminish the amount of capital they hold to support a combined $1.4 trillion of debt and debt guarantees, according the year-end 2007 figures.

Letting Fannie and Freddie off the leash at a time when more capital rather than less is required is a potentially hazardous manoeuvre, as several have been keen to point out.

James Lockhart, Ofheo director, is a long-time critic of Fannie Mae and Freddie Mac. In Ofheo's annual report to Congress, released on April 15, he noted that the "increasing pressure" on the two GSEs to support the mortgage market is "problematic" given the absence of legislation that would strengthen federal oversight of them.

Power play

Lockhart is clearly not convinced that the newly popular mortgage agencies do not still pose a threat to the wellbeing of the financial markets. He called for better oversight of the agencies and urged Congress to approve legislation that would expand Ofheo's powers. "The time to act on the legislation is now," he said, adding that both Freddie and Fannie remain "significant supervisory concerns".

"Lockhart has been dead set against a reduction of the surcharge, but the administration has put in a lot of pressure," say an agency analyst in New York.

Over the past four weeks, the relaxation of the capital cushion the GSEs are obliged to hold does appear to have helped out the mortgage market, despite Lockhart's misgivings about the long-term effects of giving the GSEs a looser leash. The mortgage basis, which measures the differential between 10-year swap rates and 30-year mortgages, contracted to 104bp on the afternoon of April 18 from 140bp on March 10. Before the subprime crisis, the mortgage basis was around 50bp.

This seems to suggest that greater liquidity and a stronger bid for mortgages has entered the market. "The idea of the capital relief is that the GSEs will buy mortgages, and the move has been supportive of the mortgage market," said Lantz.

Under the new regime, if Fannie Mae were to raise, for example, a fresh $3 billion in capital it could buy $373 billion more mortgage-backed securities and have a portfolio of around $190 billion, according to analysis conducted by Credit Suisse. Under the old regime, its purchasing power with this amount of capital would have been close to zero. "This has made a gigantic difference. It creates a lot of buying power in (the agencies') portfolio and they can buy more mortgages and package them into mortgage-backed securities. If the capital constraints were in place, they couldn't do nearly as much," says Ira Jersey, a rate strategist at Credit Suisse.

Bargain-hunting

Other analysts suggest that Fannie and Freddie will jump at the chance to buy mortgages at their current depressed prices. "They would have loved to buy mortgages when they were cheaper than they were now, but they had no capital. However, they're still pretty cheap," says one.

Of course, the relaxation of the GSE capital cushion is not the only reason that the mortgage market is functioning more healthily. On March 11, the Federal Reserve unveiled its Term Securities Lending Facility, which allows a range of mortgage-backed securities to be presented as collateral to the Fed in return for Treasuries.

Moreover, it is not clear exactly how free Fannie Mae and Freddie Mac are to use their greater purchasing power. They are still required to keep their capital ratios relatively high, and both are facing losses in the mortgage market. Freddie Mac, say sources, is particularly exposed to the subprime sector and has not yet taken the full charge related to these positions.

"They've got this exposure hanging over them. They will have to raise capital and not until they do this in earnest will they be able to do much," says one.

According to Lockhart: "The extraordinary declines in the housing and mortgage markets have greatly increased (the agencies') credit and interest rate risks". These risks have put "additional pressure on their credit management, interest rate risk management and financial modelling processes".

Fannie and Freddie's total exposure to the mortgage market grew from 8% in 2006 to 15% in 2007, and their mortgage origination increased from 37.4% in 2006 to 75.6% in 2007. It would be surprising if some very nasty earnings figures were not lurking in the wings. But the relaxation of the surcharge has created the freedom for the mortgage agencies to make a significant contribution to a recently paralysed US mortgage market. To what extent they will do so remains to be seen.

Although the GSEs were reasonably active in the mortgage market at the end of March, the quarterly earnings season is now upon them and they have had other matters to attend to. But the key to the jail cell is in their hands.

There is another theory doing the rounds on Wall Street, that the agencies might not want to restore calm to the mortgage markets too quickly because if they do so they will lose their new-found popularity and the chance to extort greater concessions from the regulators.

"Ofheo has always had an antagonistic view of the agencies, as has the Fed, the Republican party, anyone who believes in free markets basically. It is in the GSEs' interest to stay important for long enough to extract better terms," says an analyst.

This would be the equivalent of Kipling's soldiers giving only a half-hearted effort in battle so that they would be better appreciated and get more money from the Treasury. Fortunately for the British Empire, they never did.