By Kathleen M. Howley and Bryan Keogh
July 24 (Bloomberg) -- Bobby Joe Cooper says she ``kicks herself every day'' for not using a Fannie Mae or Freddie Mac mortgage when she refinanced her Terre Haute, Indiana, home three years ago.
Instead, the 29-year-old mother of three borrowed $55,000 at 5 percent, a point lower than a so-called conforming loan guaranteed by the nation's two biggest mortgage-finance companies. Cooper, the manager of Courtesy Cleaning Center on the city's south side, said she didn't understand it was a subprime mortgage, reserved for borrowers with poor credit histories, and that its rate would triple within two years.
When Cooper realized her monthly payment would rise 78 percent, ``I cried myself to sleep because I knew I wasn't going to be able to keep up.'' Cooper refinanced her home again last year, this time with a loan acceptable to Fannie and Freddie.
The two government-sponsored companies, chartered to make it easier for lenders to support home buying, have been accused of crooked accounting and criticized by Warren Buffett and Alan Greenspan for speculating, while a bank lobbying campaign sought to end the implicit U.S. guarantee of their debt. And yet, yesterday the House of Representatives voted to rescue them from losses on subprime loans with an unlimited equity infusion.
Fannie and Freddie have proved indispensable. The government and the banks that tried to rein them in now rely on the companies to pull the housing market out of its worst slump since the Great Depression and keep the global financial system from collapsing. The combination of falling U.S. home prices and the evaporation of the market for subprime mortgages has left banks and brokers with $467 billion of losses and the inability to extend credit.
`Provide Capital'
``It is absolutely right for Fannie Mae and Freddie Mac to extend their balance sheets for now,'' Jamie Dimon, chief executive officer of JPMorgan Chase & Co., said in a July 8 speech in Arlington, Virginia. ``That will provide capital directly where it is needed in the mortgage markets today.''
Congress gave Washington-based Fannie and McLean, Virginia- based Freddie the ability this year to buy ``jumbo'' loans for the first time. The mortgages for more than $417,000 made up almost a third of the U.S. market last year, according to the Mortgage Bankers Association.
As their shares dropped as much as 76 percent the past month, Treasury Secretary Henry Paulson proposed injecting capital into the companies and extending more credit should the need arise. This week U.S. lawmakers reached agreement on a modified version of the plan, which Paulson said is essential for safeguarding U.S. financial markets.
Bailout Package
The legislation passed yesterday by the House would authorize Paulson to bail out Fannie and Freddie while placing few restrictions on them. Lawmakers said they expected the Senate to approve the measure later this week, and the White House said President George W. Bush would sign it into law.
The government-sponsored companies, which buy home loans from banks and hold them or package them for sale to investors, accounted for more than 80 percent of the mortgage securities created in the first quarter, double the level of a year earlier, based on data compiled by Bloomberg. They own or guarantee almost half of the $12 trillion in U.S. home loans, and their purchases provide banks funds to offer more credit.
Fannie and Freddie increased their support for lenders at the same time that demand for bonds backed by subprime mortgages evaporated. Sales of so-called private-label bonds dropped to $46 billion this year from $707 billion in 2007 and $1.1 trillion a year earlier, according to Inside Mortgage Finance and Mortgage Bankers Association data.
Low-Cost Debt
Fannie, founded in 1938 as part of President Franklin Delano Roosevelt's New Deal, and Freddie, created in 1970 during the Vietnam War, are ``the only guys in town who are buying'' mortgages, said Josh Rosner, managing director at New York-based investment research firm Graham Fisher & Co. ``The demise of the private-label securitization market means lenders have to either hold mortgages or sell them to Freddie or Fannie.''
The newfound appreciation follows almost a decade of criticism by banks and Wall Street firms that complained the publicly traded government-sponsored companies enjoyed a competitive advantage from the implied U.S. backing of their debt. Fannie and Freddie can borrow at rates below those of mortgage competitors and other companies with top AAA ratings.
Investors demanded an average of 26 basis points to own notes issued by Fannie or Freddie instead of Treasuries two years ago, compared with 61 basis points for companies with AAA ratings and 82 basis points for banks, according to data compiled by Merrill Lynch & Co. A basis point is a hundredth of a percent.
Lobbying Group
A group of Fannie and Freddie competitors formed a lobbying group in 1999 to press for tighter regulation. FM Watch included Wells Fargo & Co. Chief Executive Officer Richard Kovacevich; Maurice ``Hank'' Greenberg, the CEO of C.V. Starr & Co. and former chief executive of American International Group Inc.; and William Harrison, head of JPMorgan before Dimon. The group has been renamed FM Policy Focus, and Kovacevich, Greenberg and Harrison are no longer members.
Fannie and Freddie started using their funding advantage to boost profits by increasing purchases of mortgages in the 1990s. Instead of insuring home loans and turning them into securities, the companies kept mortgages and some of the bonds as investments. Their holdings doubled in the five years through 2003 to $1.57 billion. The investments grew more than 10-fold since 1990.
Profits at the companies grew with their investments. Fannie Mae's net income of $8.08 billion in 2003 was more than double its total in 1999. The company earned more than New York-based Merrill Lynch & Co., the biggest U.S. brokerage firm, every year from 2000 through 2005.
The growth made some investors concerned that the two were taking too many risks, making them more like hedge funds than companies linked to the government.
No `Credible Purpose'
In August 2002, Fannie's so-called duration gap, a measure of interest rate risk, widened to minus 14 months, more than twice its maximum target at the time of plus or minus six months. The gap indicated that the average maturity of the company's mortgage assets was 14 months less than its outstanding debt.
``It would not be the end of the world at all if Fannie and Freddie no longer had new portfolio purchases,'' Buffett, the chairman of Berkshire Hathaway Inc., said in April 2005. Buffett sold almost all of his 8.5 percent stake in Freddie in 2000, citing a changing ``risk profile'' that made him ``uncomfortable,'' according to Berkshire's annual report.
Greenspan, the former chairman of the Federal Reserve, joined the critics as his 18-year tenure approached its end in January 2006.
``The Federal Reserve has been unable to find any credible purpose for the huge balance sheets built by Fannie and Freddie other than the creation of profit through the exploitation of the market-granted subsidy,'' Greenspan, now 82, said in a May 2005 speech.
`Cookie Jar' Accounting
The rising investments led Fannie and Freddie to increase their use of derivatives to hedge interest-rate risks. Derivatives are financial instruments linked to stocks, bonds, loans, currencies and commodities, or to specific events such as changes in interest rates or weather.
Freddie restated earnings from 2000 through 2002 after it replaced long-time auditor Arthur Andersen and discovered errors related to derivatives. Fannie was forced by regulators to follow suit.
A federal investigation resulted in fines from regulators who said that the companies used ``cookie jar'' reserves and accounting gimmicks to manipulate earnings. Freddie ousted Chief Executive Leland Brendsel in June 2003 and Fannie's Franklin Raines left in December 2004.
Tantalizing Profit
The profits from repackaging home loans into securities proved irresistible to Wall Street. Fees from turning mortgages, auto loans, aircraft leases and credit-card receivables into bonds almost tripled from 2002 through 2007, reaching $5.6 billion, Bank of America Corp. analyst Michael Hecht estimated five months before credit markets seized up a year ago.
Fannie and Freddie could buy or guarantee only mortgages that met their underwriting criteria and fell below a limit adjusted annually by regulators -- $322,700 in 2002.
Investment banks faced no such restraints. Bear Stearns Cos. and Lehman Brothers Holdings Inc. led in packaging $1.2 trillion of subprime mortgages into bonds in 2005 and 2006 to feed investors demanding securities that yielded as much as 10 percentage points more than mortgage bonds guaranteed by Fannie Mae and Freddie Mac.
Investor hunger encouraged lenders to issue $2.4 trillion of subprime mortgages from 2001 to 2006. The increased credit allowed more Americans to buy houses and helped push up prices 59 percent from 2000 to 2005, according to the National Association of Realtors.
House of Cards
When the economy's growth slowed in 2007, home prices declined and borrowers began to default because they couldn't pay the higher interest on their adjustable mortgages.
The rate of foreclosures rose to the highest level in at least three decades, the Mortgage Bankers Association said in a June report. One in every 501 households was in a stage of foreclosure in June, and bank seizures rose 171 percent since January, 2005, according to RealtyTrac Inc., an Irvine, California-based company that sells data on defaults.
Some of the biggest providers of mortgages collapsed or were acquired. New Century Financial Corp. of Irvine, California, failed. Calabasas, California-based Countrywide Financial Corp. was bought by Bank of America Corp. IndyMac Bancorp, in Pasadena, California, was seized by bank regulators.
The financial bloodletting since last summer stripped $2.6 trillion from the value of stocks in the Standard & Poor's 500 Index since Oct. 12, 2007, when it reached a record 1561.80.
Shares Tumble
Fannie and Freddie haven't escaped the carnage. The companies' combined losses over the past three quarters reached more than $11 billion. The total will probably climb to $48 billion by the end of next year, according to a July 18 report by JPMorgan Chase & Co. analyst Matthew Jozoff in New York.
Fannie fell as low as $6.68 on July 11 in New York Stock Exchange trading, and Freddie reached $3.89 the same day. While Fannie rebounded to $15 and Freddie reached $10.80 yesterday after Congress started approving Paulson's plan, both were trading above $60 a year ago.
When Fannie sold $3 billion of two-year notes on July 9, investors demanded an extra 74 basis points of yield to own the debt rather than Treasuries of similar maturity, more than in past offerings. Freddie paid a spread of 88 basis points to sell $3 billion of two-year notes on July 17, the widest in at least five years.
Debt issued by Fannie and Freddie is held by banks, insurance companies, pension funds and foreign governments. Led by China and Japan, non-U.S. investors own more than $1.3 trillion of their bonds, according to the Treasury's most recent ``Report on Foreign Portfolio Holdings of U.S. Securities.''
`Disastrous Consequences'
``The obligations they have outstanding, something in the order of $5 trillion, are so large that there would be a worldwide financial catastrophe should they default,'' said former St. Louis Federal Reserve President William Poole in an interview. ``The financial system would seize up.''
Fannie and Freddie would cost U.S. taxpayers an estimated $25 billion over two years under Paulson's plan if a bailout was necessary, the Congressional Budget Office said July 22.
While there is probably a ``better than 50 percent'' chance taxpayer funds won't be needed, the CBO said, ``many analysts and traders believe that there is a significant likelihood that conditions in the housing and financial markets could deteriorate more than already reflected'' in the companies' finances.
`Stupid Question'
``Such continuing problems would increase the probability that this new authority would have to be used,'' said the CBO, a nonpartisan agency in Washington that provides economic and budget analysis for lawmakers, in its report.
As Terre Haute's Cooper discovered, the housing boom was fueled by lenders that moved away from the fixed-rate loans and 10 to 20 percent down payments that Fannie Mae and Freddie Mac prefer. Instead, the mortgage companies offered adjustable-rate loans with initially low teaser rates, no money down and even cash back after the deal was completed to thousands of buyers of limited means.
When Cooper's interest rate jumped to 13 percent, her payments climbed to $800 from $450 a month. She started missing installments, and subprime loan servicers began calling her at work and asking why, Cooper said.
``I told them, I can't pay because you jacked up my interest rate to a level that no normal person could handle,'' the manager of the dry cleaner said. ``I thought it was kind of a stupid question.''
To contact the reporters on this story: Kathleen M. Howley in Boston at kmhowley@bloomberg.net; Bryan Keogh in New York at bkeogh4@bloomberg.net
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