Fannie, Freddie Post Biggest Profits on Mortgages Since 1998

By Jody Shenn

Aug. 27 (Bloomberg) -- The crisis of confidence that sent Fannie Mae and Freddie Mac debt costs to record highs above U.S. Treasuries is also providing the mortgage-finance companies with the biggest profits on new investments since at least 1998.

The current-coupon mortgage bonds Fannie and Freddie buy yield about 40 basis points, or 0.40 percentage point, more than what they pay to borrow by selling benchmark bonds, according to Citigroup Inc. The difference exceeded 20 basis points only twice in the 10 years through 2007 -- in 1998 and 2003.

The gap enables the government-chartered companies to offset some of the credit losses on mortgages they own or guarantee and eases pressure on U.S. Treasury Secretary Henry Paulson to step in with a bailout. The companies, which profit from their $1.6 trillion of mortgage investments, have tumbled more than 85 percent this year as investors became alarmed at growing mortgage delinquencies and the rising cost of their debt.

``It's ironic,'' said Moshe Orenbuch, an analyst at Credit Suisse Group in New York, adding that their interest margin is likely to continue to widen. ``From Fannie and Freddie's perspective, there's actually better investments now.''

Congress created Fannie and Freddie to expand homeownership and provide market stability. They make money by financing mortgage-asset purchases with low-cost debt and on guarantees of home-loan securities they create out of loans from lenders.

Interest Income

Washington-based Fannie said last month net interest income rose to $2.1 billion in the second quarter, from $1.7 billion in the first quarter. The company's profit on its investments expanded to 100 basis points from 82 basis points, according to Credit Suisse.

Freddie's net interest income jumped 92 percent to $1.5 billion. The annualized profit per dollar of investments rose to 80 basis points from 48 basis points.

``They, at the increment, are very, very profitable,'' said Dan Fuss, vice chairman of Loomis Sayles & Co. in Boston and co- manager of the $17 billion Loomis Sayles Bond Fund. ``If they can continue to do anything close to business as usual, they are immensely profitable.''

The Loomis Sayles fund owned $260.3 million in Fannie and Freddie equity and $141.3 million in debt as of June 30, according to the firm's Web Site.

Attractive Funding

``Our funding costs remain attractive, particularly based on the opportunities to purchase mortgage assets at attractive spreads,'' Freddie spokesman Michael Cosgrove said. A Fannie spokesman, Jason Lobo, declined to comment.

Fannie and Freddie shares fell this year and their borrowing costs rose amid concern they don't have enough capital to weather the biggest housing downturn since the Great Depression. The companies had $14.9 billion of losses in the past four quarters as late payments on mortgages rose to the highest on record.

Freddie on Aug. 19 sold $3 billion of five-year reference notes to yield 113 basis points more than five-year Treasuries, the most in at least 10 years. Fannie sold $3.5 billion of three-year notes at a record spread of 122.5 basis points on Aug. 13.

The crisis of confidence prompted Paulson to draw up a rescue plan last month giving him authority to inject unlimited amounts of capital into the companies.

While the difference between their cost to borrow and the returns they get on new investments has widened, losses are depleting capital and causing the companies to rein in their purchases of securities.

Both said they plan to limit growth in their portfolios to preserve capital, after boosting holdings by $115 billion in the first seven months of this year. Their reluctance to purchase is contributing to higher yields on mortgage assets

Cutting Back

Fewer purchases by Fannie and Freddie means the companies' debt costs are having little influence on mortgage bond prices and home-loan rates, according to some analysts. Yields in the $4.5 trillion market for agency mortgage bonds, those issued by Fannie, Freddie and Ginnie Mae, guide rates on new home loans.

``It would make a difference if they were increasing their portfolios,'' said UBS AG mortgage analyst Laurie Goodman in New York, whose team was ranked No. 1 in a 2007 poll by Institutional Investor magazine for ``pass-through'' agency mortgage bonds.

Fannie and Freddie's holdings are shrinking at a monthly rate of about $20 billion because of refinancings, home sales and borrower defaults, according to an Aug. 21 report from New York-based Citigroup analysts Scott Peng, Brad Henis, and Brett Rose. That money can be reinvested into higher yielding securities.

That is one reason ``there is no pressing need'' for a bailout, they wrote in the report, titled ``All That Sound and Fury, Signifying Nothing New.''

The companies are also boosting fees to guarantee home-loan securities, off-balance-sheet obligations for which they don't need to borrow. Fannie plans on Oct. 1 it will double to 50 basis points an upfront ``adverse market delivery charge,'' introduced this year for every mortgage the company buys or guarantees.

To contact the reporter on this story: Jody Shenn in New York at jshenn@bloomberg.net.