Fannie and Freddie Ride Again

The subprime mess provides an opportunity for Fannie Mae and Freddie Mac to salvage their reputations.

Where there is crisis, there is also opportunity. The turmoil afflicting parts of America’s giant residential mortgage market has already claimed dozens of casualties, including two Bear Stearns hedge funds that bet the wrong way on structured products backed by loans to subprime borrowers. But Fannie Mae and Freddie Mac, the government-chartered siblings that tower over the market, spy gold in the rubble — or at least a chance to polish their tarnished reputations.

Founded to promote affordable housing, Fannie and Freddie make life easier for lenders by buying their home loans and packaging them as securities, or by guaranteeing third parties’ issuance of mortgage-backed bonds. Between them they hold or support assets worth more than $4 trillion. It was, therefore, no trifling matter when they were found to have misreported earnings in 2001-04 — by a combined $11 billion. Top executives were jettisoned, huge fines imposed, and the pair were hit with portfolio caps and higher capital requirements.

The journey to redemption has been backbreaking. They have spent billions of dollars on new systems and controls. At one point, more than 60 “restatement teams” were beavering away at Fannie, trying to make sense of its labyrinthine books. Their work is finally paying off. Fannie said recently that it will return to timely reporting next spring, earlier than expected, while Freddie will do so this year. The surprise lifted Fannie’s shares, which are up by around 13% this year.

Fannie and Freddie also hope to regain credibility by portraying themselves as buyers of last resort in the subprime market, as private lenders belatedly tighten standards and investors run from toxic mortgage-backed debt. They have pledged to buy tens of billions of dollars of new subprime mortgages, and are working on products to alleviate the plight of the worst-hit borrowers. As a result, their market share has grown in recent months, though not quite to the level it was at before the scandals. Remarkably, Fannie’s portfolio grew at an annual rate of 14% in May. The news this week of problems at another group of hedge funds where subprime bets turned sour, run by United Capital, is likely to send more business their way.

Some question the motives of the so-called government-sponsored enterprises (GSEs), accusing them of using the crisis to cherry-pick the best subprime customers without taking much extra risk. “They paint themselves as saviours, but they are essentially opportunists,” says Bert Ely, a consultant and long-time critic of the pair.
But with Congress having declared war on “predatory” lending, the move is politically smart. Nor can anyone deny that Fannie and Freddie are well placed to take a lead. Sentiment has swung quickly away from exotic adjustable-rate mortgages towards the safer fixed-rate products that are their bread and butter. And because they were forced to show restraint while others grabbed every bit of business going, their portfolios have plenty of room to grow. James Lockhart, the director of the Office of Federal Housing Enterprise Oversight (OFHEO), the GSEs’ regulator, sees it as an opportunity for them to educate the market in sound underwriting.


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