Fannie Mae could be hit hard by housing bust
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Mortgage giant could lose $29 bln, long-term bear argues in investor letter
By
Alistair Barr, MarketWatch
Last Update: 12:19 PM ET Sep 18, 2006
SAN FRANCISCO (MarketWatch) -- The worst of Fannie Mae's regulatory troubles may be behind it, but one longtime skeptic of the mortgage giant thinks it could face bigger problems from trouble in the U.S. housing market.
Fannie's main business is buying mortgages from banks and other lenders, packaging them into so-called mortgage backed securities (MBS) and selling them on to other investors. The company gets fees for providing credit guarantees on these pools of loans. Fannie is currently responsible for more than $1.6 trillion of MBS and is involved in the financing of roughly a fifth of all U.S. mortgages.
By taking mortgages off the hands of other lenders, Fannie helps them free up more capital so they can sell more mortgages.
It held a little more than $730 billion in mortgage-related securities on its balance sheet at the end of June.
Subprime exposure
Fannie has traditionally specialized in higher-quality, fixed-rate mortgages, which are less vulnerable to interest-rate fluctuations and volatility in the housing market.
But the company has been investing more in subprime MBS in recent years. Subprime loans are sold to home buyers who fail to meet the strictest lending standards, so this area of the mortgage market is expected to be hit harder by any housing downturn.
Fannie and Freddie bought 25.2% of the record $272.81 billion in subprime MBS sold in the first half of 2006, according to Inside Mortgage Finance Publications, a Bethesda, Md.-based publisher that covers the home loan industry.
In 2005, Fannie and Freddie purchased 35.3% of all subprime MBS, the publication estimated. The year before, the two purchased almost 44% of all subprime MBS sold.
Ofheo, Fannie's regulator, has noticed that the company has increased its subprime exposure.
"They've expanded in that area in recent years, but it's still not an enormous part of their business," Andrew Lawler, chief economist at Ofheo, said. "It's an area we're increasingly looking at because they're increasingly involved in it."
An Ofheo report due out later this year is expected to show Fannie's subprime exposure is "generally moving up," he added.
Given those recent moves, Berg said it's not implausible that 15% of Fannie's mortgage exposure is subprime.
If a housing slowdown causes subprime foreclosure loss rates to rise to between 6% and 8%, Fannie could lose $22 billion to $29 billion, Berg estimated in his letter.
That's more than half of the roughly $40 billion in capital that Fannie had at the end of March, according to Ofheo.
"There's a high probability of a sharp increase in credit losses in the second half of 2007 and into 2008," said Robert Lacoursiere, an analyst at Banc of America Securities. "This will be more pronounced in subprime and will hit earlier in that area, too."
Subprime stress
Early signs of stress are beginning to appear.
H&R Block announced an unexpected $102 million charge in late August related to its Option One mortgage business, which specializes in home loans to borrowers with credit scores at the lower end of the spectrum. The company said the losses cover loans it could be required to buy back should a borrower default on the first payment.
Mortgage-lender National Citysaid recently that, while it has refrained from entering the riskier areas of lending, it has seen a marked increase in first-payment defaults on loans.
In California, one of the hot markets where home prices soared in recent years, defaults surged 67% in July from a year earlier.
Mortgage-insurance specialist MGIC Investmentreported a 17.35% delinquency rate on A- rated and subprime loans as of the end of June. That's up from 12.38% in late 2002.
Fannie may have increased exposure to the subprime market in response to restrictions on its growth by regulators, Lacoursiere explained.
Subprime mortgage debt offers higher yields than better-quality loans. So one way for Fannie to generate more profit in the midst of restrictions on its portfolio is to invest in higher-yielding debt, he said.
"They've been getting into asset classes that haven't been a big specialty for them in the past," the analyst added. "Combine that with a credit environment in the mortgage market that is fundamentally deteriorating, and you start to wonder whether they're doing something that they may regret."
The problem is exacerbated by the fact that Fannie Mae hasn't disclosed financial statements for more than two years, Berg said in his letter. That makes it hard to gauge Fannie's true exposure to subprime mortgages and the housing market as a whole.
"Simply writing down these points in summary fashion illustrates the unprecedented and complex puzzle of a $46 billion market cap company that doesn't file financial statements," he wrote. "Moreover, the company has instituted a share buyback for the benefit of employees in the midst of this void! You can't make this stuff up."