Fannie Mae and Freddie Mac
May Have Further to Fall

Mortgage giants Fannie Mae and Freddie Mac could one day be an attractive way to bet big on a recovery in the housing market.

But fourth-quarter numbers released this week suggest that their debt-laden balance sheets could push the company's shares much lower before they go higher.

Fannie Mae and Freddie Mac, which guarantee mortgages as well as hold them on their own books, reported multibillion-dollar losses for the period and upped their expectations for credit losses as the housing crunch worsens.

The results were well anticipated by the companies' shares. Fannie's stock was off 32% this year before its results came out Wednesday, while Freddie's was down 26% before its earnings yesterday. In 4 p.m. composite trading yesterday on the New York Stock Exchange, Fannie's shares were up 63 cents to $27.90. Freddie's shares ended at $24.49, down 60 cents.

It appears that investors think most of the bad news is priced into the stocks. However, closely followed measurements of capital in the fourth-quarter results show that Freddie increased its leverage -- which calculates how many times assets exceed the company's net worth -- in the fourth quarter. That leaves the company more exposed than before to downturns in its business. And while Fannie's leverage didn't move much from the third to the fourth quarter, it remained at a level far above that of other financial institutions.

A lack of capital could prompt dilutive stock issues from Fannie and Freddie, which operate under government charters. Fannie issued $7 billion of preferred stock to bolster its capital in December and Freddie issued $6 billion. This week, both companies said they had adequate capital at the end of the fourth quarter. But both noted that they may take actions to raise more capital if business turns out to be worse than expected.

"We think the market will remain concerned that financial forces will undermine the highly leveraged [government-sponsored entity] business model, possibly forcing another round of capital issuance to bolster their balance sheets," Merrill Lynch analyst Kenneth Bruce wrote in a recent research note. Last week, Mr. Bruce downgraded his ratings on Fannie and Freddie shares to "sell."

One indicator that analysts track to get an idea of leverage is a calculation Fannie and Freddie do of their net worth, taking the current market values of most of their assets and subtracting their liabilities.

By that measure, Freddie looked a lot more risky at the end of the fourth quarter than it did at the end of the third. At the end of the fourth quarter, Freddie reported that its net worth was $12.6 billion using market values, while its assets were worth $800 billion, or 64 times more. This was up from 33 times at the end of the third quarter. The leap was due to big declines in the value of the mortgages it holds and an increase in expected losses for the mortgages they guarantee.

Fannie's leverage, using this metric, stayed at around 25 times from the third to fourth quarters. But Fannie's leverage would have gone up if it hadn't issued new preferred shares.

The fair value approach has flaws, say analysts. For example, it can often reflect billions of dollars in losses that the companies may never actually close out and realize. Indeed, Freddie said this quarter that its net worth available to common shareholders was just $300 million at the end of the fourth quarter, or a mere 45 cents a common share.

Despite its vagaries, fair-value net worth is followed closely by Fannie and Freddie's regulator, the Office of Federal Housing Enterprise Oversight. Its views matter to investors because it has a big say on the adequacy of capital at Fannie and Freddie and will influence the companies' capital-raising plans.

In testimony before the Senate Banking Committee earlier this month, Ofheo's director, James B. Lockhart III, compared the fair value of net worth to Fannie and Freddie's total book of business, which combines the on-balance-sheet assets plus the mortgages that Freddie and Fannie have guaranteed.

Under that calculation, Fannie's total book of business was 81 times its fair-value net worth at the end of the fourth quarter, and Freddie 167 times. This makes the companies' cushion for losses look even thinner.

In an interview, Mr. Lockhart noted that this approach is just one of several ways to gauge capital, but he added that it shows that, "a relatively small fluctuation in credit risk can have a significant impact on capital."

Because of flaws in the fair-value approach, some analysts think investors will focus more on book-value measured according to generally accepted accounting principles, or GAAP. This still makes Fannie highly leveraged at 20 times GAAP net worth and Freddie at 30 times at the end of last year. Using GAAP, the 20 largest U.S banks had much lower leverage of about 11 times, according to SNL Financial.

If Fannie and Freddie raise capital to bring their leverage ratios closer to those of U.S. banks, it might allay concerns about safety and soundness. But it might make the companies less attractive to investors.

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