Monday, July 7, 2008
Mortgage Giants Take Hit On Fears Over Capital
Investors dumped shares and bonds of
Fannie Mae and Freddie Mac, signaling a dramatic loss of confidence in two government-sponsored mortgage companies considered crucial to restoring the health of the housing market.
Shares of the two companies dropped Monday to their lowest levels in more than 14 years, and at one point, Freddie Mac had lost nearly 30% of its value.
Home buyers are having a tougher time getting mortgages as lenders feel the squeeze from defaults. IndyMac Bancorp Inc., a big mortgage lender during the housing boom, said Monday it will stop making most types of home loans.
IndyMac specialized in loans for borrowers who didn't fully document their income or assets. But it has suffered from soaring losses on these loans and couldn't raise additional capital. Monday's move will force IndyMac to eliminate 3,800 of its 7,200 jobs.
Investors are growing concerned that Fannie and Freddie will have to issue billions of dollars in stock, diluting existing shareholders, or face a more dire reckoning.
While the stock declines of Fannie and Freddie were sharp, the biggest impact from their troubles could come in the mortgage market. If the companies fall short of capital, they would have a harder time buying and guaranteeing mortgages. That would raise home buyers' borrowing costs and likely drive down home prices further. On Monday, investors sold off the debt of the two companies, effectively making it more expensive for them to borrow.
Congress and the White House are counting on Fannie, Freddie and the Federal Housing Administration to prop up the mortgage market as other financial institutions shun what they see as a treacherous business. Fannie and Freddie "are critical to keeping the economy going," said Frederick Cannon, chief equity strategist at Keefe, Bruyette & Woods in San Francisco.
Fannie and Freddie are government-chartered companies that provide the bulk of funding for U.S. home mortgages. They own or guarantee about $5.2 trillion of home mortgages, or roughly half of all home loans outstanding.
Investors have grown increasingly jittery in recent weeks about the ultimate losses the companies face on their vast holdings of mortgages and related securities. The two have suffered combined losses of more than $11 billion in the nine months ended March 31. Analysts expect the toll to worsen as more homeowners default.
While Fannie and Freddie have bought insurance to cover some losses on mortgage defaults, its insurers are suffering from their own huge losses. Several of the insurers have had their financial-strength ratings cut recently by Moody's Investors Service and Standard & Poor's. If Fannie and Freddie conclude the insurers can't be counted upon, they would likely have to set aside more reserves for potential losses.
On Monday, a Lehman Brothers report said accounting rule changes could force Fannie and Freddie to raise tens of billions of dollars in new capital. Few expect Washington officials to let that happen, because the changes would make it difficult for the companies to buoy the housing market. The Lehman analyst agreed, saying, "We cannot imagine such an outcome occurring." But the report served as a fresh reminder of the thin layer of protection the two companies have against new losses, and helped send the shares downward.
After rebounding from midday lows, Fannie shares were down $3.04, or 16.2%, to $15.74 on the New York Stock Exchange, while Freddie stock was down $2.59, or 17.9%, to $11.91. It was the lowest close for Fannie since 1992 and the lowest for Freddie since 1993. In the past year, Fannie shares have lost 76% of their value, while Freddie is down 80%.
If financial problems forced Fannie or Freddie to scale back purchases or guarantees of mortgages, interest rates on new home loans could rise sharply. But David Palombi, chief spokesman for Freddie, said the company has more capital than required by its regulator and expects "to remain in our traditional role stabilizing the market.
At Fannie, spokesman Brian Faith said: "We are managing our business and maintaining a capital position that will allow us to fulfill our mission to provide liquidity and stability to the housing finance system."
Because investors believe the government probably would bail out the companies in a crisis, they are able to raise money on international bond markets at relatively low rates. But their borrowing costs have risen recently. Two-year bonds issued by Fannie were yielding 0.74 percentage point over Treasury securities Monday afternoon, up from 0.66 percentage point at the end of last week and 0.615 at the end of June. Yields on three-year Freddie Mac bonds rose to 1.15 percentage points over Treasurys, compared with 1.06 points on July 3, according to data from FTN Financial.
In a worst-case scenario, if Fannie and Freddie couldn't handle their obligations and the government had to rescue them, the companies' shares probably would be worthless, said Josh Rosner, an analyst at Graham Fisher & Co., a New York research boutique.
Shares of the two companies soared in the 1990s as they posted huge profits, driven in part by their connection to the government, which let them borrow more cheaply than their rivals.
The housing crisis has turned the tables. Right now, the government cares far more about keeping Fannie and Freddie healthy so they can continue to bolster the housing market than it does about the companies' shareholders. Stock investors appeared to realize in recent weeks that the future for shareholders was bleak. Investors who hold Fannie and Freddie bonds appear less concerned because the debt is perceived to carry an implicit government guarantee.
Freddie in May announced plans to raise about $5.5 billion of capital by selling common and preferred shares. But the company still hasn't made those offerings and now says they are unlikely before it announces second-quarter results in August. Fannie raised $7.4 billion in capital in April and May.
Prices are also falling on bonds backed by mortgages that are guaranteed by Fannie and Freddie. Bonds backed by home loans guaranteed by Fannie Mae Monday afternoon were yielding around 2.4 percentage points over Treasury securities, up from 2.33 percentage points at the end of last week and 1.9 percentage points six weeks ago. At the height of the credit crisis in mid-March, that "spread" jumped to 2.9 percentage points, according to FTN Financial.
The wider spread "reflects increased selling pressure, which we think is tied to the concerns about whether Fannie and Freddie have to raise more capital," said Dominic Konstam, head of interest-rate strategy at Credit Suisse in New York.
The Cost of Protection
The cost of protecting against a default in debt issued by Fannie and Freddie surged. On Monday afternoon, investors were agreeing to pay $210,000 annually to insure $10 million of Fannie's or Freddie's subordinated debt from a default over five years, up $25,000 from the morning. That same insurance cost $173,000 annually on July 1, according to Phoenix Partners Group. The swaps are also bought and sold by hedge funds and traders that don't own the actual bonds but are betting on the fortunes of Fannie and Freddie.
In Congress, many Democrats and Republicans have said the best way to improve confidence in Fannie and Freddie is to overhaul regulatory supervision of both companies. The Senate could vote as soon as this week on a measure that would create a new regulator for the companies with stronger powers. The House already has passed such legislation.
Sen. Mel Martinez, Republican of Florida, said the stock drops are a "reality check." He added, "It's all the more reason for us to get this [legislation] done."
The Bush administration and legislators from both parties want Fannie and Freddie to keep pumping money into mortgages, although that goal at times contradicts their desire that the companies shore up their financial standing to reassure markets. The Bush administration supported recent moves to ease capital requirements at both companies. Some Democrats complained that Fannie and Freddie haven't used their new flexibility to rescue enough homeowners from foreclosure.