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Fannie's And Freddie's Last Man Standing

This article is more than 10 years old.

Before Fannie Mae and Freddie Mac were taken over by the federal government last fall, before they teetered on the verge of collapse, before they gushed quarterly losses of $25 billion apiece, these two mortgage giants were closely monitored by more than a dozen of the sharpest minds on Wall Street. No surprise there. At their peak, they had a combined market capitalization of $138 billion.

That was then. As government-controlled firms with a $5 trillion balance sheet between them, they are now worth only about $3 billion. The analysts are gone too--except Bose George.

George, who works for Keefe Bruyette Woods, has been closely following the two government-sponsored enterprises (GSEs) since they were seized last fall, after years of covering the broader mortgage market. Due to a low-profile public relations strategy, George can't pepper top brass with questions, especially since they don't even host quarterly analyst calls. But using regulatory filings and government press releases, George gauges how much trouble these two are in and what their future will look like.

Forbes: So you are the last Wall Street analyst focusing on these two companies, and they shoulder 90% of America's mortgage market. How does that make you feel?



Bose George: It is a bit surprising. Although my guess is there are a lot of people doing similar work but they don't publish estimates and go to that next step of coverage, where you try to figure out what is going to happen from an earnings perspective.

At the height of their market capital, how many analysts were covering these two?

At their peak, roughly 20, maybe 25.

What is KBW's interest in Fannie and Freddie at this point, now that they trade for less than $2?

It's really more from the perspective of the role they play in the mortgage market. They were always important players but now they are even more critical, since they are guaranteeing a substantial percentage of the mortgages coming through. Clearly, they are crucial in terms of keeping track of trends in the mortgage market.

In terms of Fannie and Freddie in their current state, where's the value and where's the liability?

We feel it's going to be pretty difficult for them to generate money. The companies have significant holes, clearly, in their capital. They owe the government roughly $50 billion each. They are continuing to generate losses, primarily because they are building up their loss reserves to levels in line with expected losses.

Once you get past that point, you still have entities with no capital. So if you want to run them like banks, you still have a capital hole that needs to be filled. That's really the crux of the problem. They have no capital and this large debt to the government as well.

What about their stocks?

It seems like [it] eventually goes to zero, but it could have a lot of ups and downs before it gets there. It could continue to be a trading game for quite a while.

How much do you think they'll lose in all?

The $400 billion is the line they have from Treasury. Our estimates through next year have them losing between $150 and $200 billion. If you look at losses on similar portfolios at other institutions, or market expectations for losses for mortgage-backed securities, you can come up with higher loss estimates as well. That [$400 billion] number isn't unreasonable in that context.

But their delinquency numbers are still reasonably good relative to the rest of the market. So we haven't gotten to a number that high.

Can Fannie Mae and Freddie Mac make money the way they used to, borrowing cheap and lending out for slightly more?

If there was an option to keep them in their current form with their very large portfolios, theoretically they'd be making enough to pay the government dividend, but the problem is they'd still have zero capital.

If you did the reconstitute option as described in the Government Accountability Report, you would still have companies with $5 trillion in on-balance- and off-balance-sheet liabilities and you'd still need a couple hundred billion dollars on day one to get them going.

The more likely scenario is that they'll just have to run off their portfolios, because they don't really serve any purpose [investing in mortgages] and they've caused a lot of problems over the last few years doing it.

When you say run off, do you mean let them amortize, or let the mortgages reach maturity, or do you think Fannie and Freddie will be having a garage sale soon?

I don't think they'll sell. Right now the mortgage market is too delicate. It makes more sense to just let them run off. They could end up holding the subprime Alt-A stuff for a while. And that stuff could get modified.

It's just not good idea to have the Fed buying on one side and Fannie and Freddie selling on the other. For now, the status quo--just letting everything run off--seems the most likely course of action.

What's the timeline in terms of changing the shape of these two institutions?

In the next couple of years it would be pretty hard to change them materially, because any change would cause them to realize their losses and it will take them longer to build reserves. And house prices still need to stabilize.

Once the Fed stops buying agency MBS [mortgage-backed securities]--which at its current rate will probably happen next spring--at that point they really don't want to put pressure on the market because the Fed won't be the incremental buyer anymore. Our political analyst, here, Brian Gardner, says it will be 2011 when they finally sort this out a little.

What's the risk to taxpayers of having so many mortgage-backed securities on the Federal Reserve's balance sheet? Is it becoming the new Fannie and Freddie?

Since their securities were already guaranteed by Fannie and Freddie, and since they are essential owned by the government, it doesn't put incremental credit risk on the government but it does put incremental interest rate risk on the government.

All these years they've been buying coupons at 4%--coupons very few private buyers would want to buy. If rates go up in the next few years, they are going to have securities with significant mark-to-market losses. Depending on what they do, the interest rate side of it is going to be a negative.

No one ever talks about that interest rate risk.

No, they don't really. But the Fed is planning to hold these to maturity so it doesn't have to mark to market. They have an infinite balance sheet, but it's a loss in a different way. For a private lender it would be a meaningful issue, because they have capital trapped in something. But for the Fed, it's not the same. With quantitative easing, the Fed can easily print money.

How do we rein in the role of the GSEs and the Federal Housing Administration in backstopping the market?

One first step is taking the jumbo mortgage rate back down from $729,000 to $417,000. That would open up a fair amount of the market to private lenders.

But the banks don't want that to happen, because they don't have the capital to issue loans, so they're happy to originate loans and sell them to the GSEs. Once banks do [have] enough capital, you will see some opposition to them gobbling up everything. Because in the end, private capital would certainly want some of these returns.