Is Fannie Mae Toast?

Fannie, of course, occupies a curious middle ground between the public and private sector as a result of its privatization in 1968 as a Government Sponsored Enterprise, or GSE. While owned by its shareholders, Fannie is regulated by a government agency and is able to borrow money cheaply, thanks to an implicit guarantee by Uncle Sam. It uses those funds to buy and securitize home loans — lots of them. At year end, the company owned in its portfolio or had packaged and guaranteed some $2.8 trillion of mortgages or 23% of all U.S. residential mortgage debt outstanding.

Of late, however, Fannie's prospects have darkened notably. The company lost $2.6 billion last year as a surge of red ink in the final two quarters more than wiped out a nicely profitable first half. And by late last week, credit-market jitters had penetrated the once-unassailable hushed precincts of the market in Fannie debt.

In the wake of margin calls on collateral at the investment concern Carlyle Capital, yields on guaranteed mortgage securities issued by Fannie and its GSE sibling Freddie Mac (FRE) rose to their highest level over U.S. Treasuries in 22 years. Likewise credit default swaps, measuring market concerns over the safety of Fannie corporate debt, have ballooned out to 2% of the insured amount from 0.5% just four months ago.

Company executives attribute such concerns to what Fannie CEO Daniel Mudd last month called "the toughest housing and mortgage market in a generation." He also said that much of 2007's loss came from reducing to market levels the value of derivatives that Fannie uses to hedge its interest-rate risk. And those accounting moves should reverse and fatten earnings in the fullness of time once interest rates stop dropping.

But, if the truth be known, a considerable portion of Fannie's losses also came from speculative forays into higher-yielding but riskier mortgage products like subprime, Alt-A (a category between subprime and prime in credit quality) and dicey mortgages requiring monthly payments of interest only or less. For example, Fannie's $314 billion of Alt-A — often called liar loans because borrowers provide little documentation — accounted for 31.4% of the company's credit losses while making up just 11.9% of its $2.5 trillion single-family-home credit book. Fannie was clearly looking for love — and market share — in some of the wrong places.

Likewise, Barron's has found other areas that may bode ill for Fannie's prospects. Its balance sheet is larded with soft assets and understated liabilities that would leave the company ill-equipped to weather a serious financial crisis. And spiraling mortgage defaults and falling home prices could bring a tsunami of credit losses over the next two years that will severely test Fannie's solvency.

Should Fannie or the similarly hobbled Freddie Mac buckle, the government would no doubt bail them out and honor their debt and mortgage guarantee obligations. Fannie common and preferred shareholders would likely suffer grievously in such a scenario.

Fannie, for its part, insists it's more than adequately capitalized to withstand any future stress. The company also contends that as a result of tightening its standards and making fewer risky loans, the quality of its book of business will improve mightily.

But some financial leaders aren't so sure. At a conference several weeks back, William Poole, president of the St. Louis Federal Reserve Bank, said that the GSEs (clearly a reference to Fannie and Freddie) appeared to be insufficiently capitalized to handle the kind of losses suffered by U.S. major banks in the past six months. "I do not have any information on the GSEs that the market does not have," he said. "Nevertheless, in assessing the risk of further credit disruptions this year, I would put the GSEs at the top of my list of sources of potentially serious trouble."

And, in commenting on the government's "too big to fail doctrine" for financial institutions, he said: "First, firms in trouble ought not to be bailed out, unless the bailout takes a form that imposes heavy costs on managers and shareholders."