Fannie and Freddie pullback would devastate economy

By Patrick Rucker - Analysis

WASHINGTON (Reuters) - If anyone thinks the current U.S. housing downturn is bad now, things would get far worse if Fannie Mae or Freddie Mac to suddenly stop buying mortgages, a move that would drive up the costs of home loans and devastate the economy. Fannie Mae and Freddie Mac, the nation's two largest sources of mortgage finance respectively, recently reported combined losses of $3.5 billion. Borrowing costs have skyrocketed and investors have erased billions of dollars in each company's equity market capitalizations. Few think the two companies are likely to pull out of the housing market, even temporarily. However, if the stream of home loan failures were to force the companies to suspend new mortgage investments, the market for mortgage bonds would "freeze up," said Tom Sowanick, chief investment officer of Clearbrook Financial LLC in Princeton, New Jersey.

Already, the housing slowdown has subtracted about 1 percentage point from growth in inflation-adjusted gross domestic product so far this year. Taking Fannie Mae and Freddie Mac out of the home loan business would flatten the already listless real estate market, said Robert MacIntosh, chief economist with Eaton Vance Management in Boston. "It would be devastating," he said. "Why would anyone consider buying a house if the two biggest ultimate credit givers and lenders to the housing industry shut down?"

While Fannie Mae and Freddie Mac do not offer credit directly to borrowers, they do buy home loans and repackage them as investments for Wall Street. The companies also buy mortgages to hold in their money-making investment portfolios. Both steps make the market more liquid by taking long-term investments off a lender's books.

Fannie Mae and Freddie Mac own or guarantee a combined $4.8 trillion of U.S. home mortgage loans of more than 40 percent of the total outstanding. That size, in part, explains why Fannie Mae and Freddie Mac are likely to survive the current housing and credit downturns. Another factor is that these companies were relatively cautious during the recent housing boom and did not make big bets on the risky subprime market, which involves borrowers with damaged credit. While Fannie Mae and Freddie Mac expect the number of failing mortgages on their books to double, that still represents less than 0.12 percent of the home loans they guarantee for investors. And maybe most importantly, the companies benefit from their status as government-sponsored enterprises, which many investors treat as a guarantee of a federal bailout if either were to stumble.

Fannie and Freddie also have credit lines to the Treasury Department, which have never been tapped, fostering the perception that they are wards of Uncle Sam. The companies are simply so large and risk-averse that they set a standard for the industry that would be hard to replicate if they were to step away from the market, said Jim Vogel, who tracks the companies for FTN Financial in Memphis, Tennessee. "They are like the U.S. Treasury of the mortgage market," said Jim Vogel, who tracks the companies for FTN Financial in Memphis, Tennessee. "The general mortgage-backed security trades on the spread set in the Fannie and Freddie market."

If Fannie Mae and Freddie Mac were to step away from the mortgage investments, it would not only send the mortgage market into a devastating tailspin, but the broader market as well, which is why many observers say it simply will not happen.

"It would aggravate the liquidity crunch. The psychological impact would be huge. The GSEs have been seen as the backstop buyers for all types of mortgage paper," said Wan-Chong Kung, senior portfolio manager at FAF Advisors at Minneapolis. But most agree with MacIntosh when he says: "It would be devastating -- but I don't think that would happen at all, there is no chance of that." And any move away from the mortgage market would destroy their stock prices -- both of which are already trading at around 10-year lows. "Fannie Mae and Freddie stocks would collapse because there would be no growth prospects," for the companies, Sowanick added.

Dan Fuss, vice-chairman of Loomis Sayles, which manages $100 billion in fixed-income assets, said he doesn't believe Fannie and Freddie will stop buying mortgages. And he points out: "You need a public policy response to the housing crisis."