Continuing Financial Strain at Fannie and Freddie Unnerves Investors, Impedes Housing Recovery 

Any sighs of relief following the announcement of a contingency government rescue plan for Fannie Mae and Freddie Mac were premature.  After easing initially, market pressures on the government services enterprises (GSEs), cornerstones of the secondary mortgage market, have intensified again, fueling speculation that Treasury Secretary Henry Paulson may have to provide the direct government assistance he proposed in the hope that offering the aid would ensure that it would not be needed.  

Shares of both Fannie and Freddie plummeted by nearly 24 percent in two days of trading last week as investors responded to an article in Barrons, speculating that a government bailout of the companies was likely and would probably wipe out shareholders.  The stock market battering and uncertainty about the GSEs’ financial future forced Freddie to pay the highest premium in a decade to investors purchasing the company’s mortgage-backed bonds – 1.13 percent above the comparable federal Treasury rate, compared with a low of 0.6 percent earlier this year.

Treasury officials repeated their assurance that they have no plans to use the authority (granted in the sweeping housing assistance measure Congress enacted recently) to invest unlimited funds, if needed to keep the GSEs afloat.  But investors remained concerned that, despite the assurances of federal backing, Fannie and Freddie will not be able to raise the capital they need to offset their mounting portfolio losses and remain active purchasers of new and refinanced mortgages. 

“I think every day that goes by without the companies raising capital, the possibility of the Treasury Department stepping in increases,” Paul Miller, an analyst at Friedman, Billings, Ramsey & Co. told the Wall Street Journal. 

A Self-fulfilling Prophesy

William Gross, chief investment officer of Pimco, a giant money management firm, agreed.  “Paulson can play this game for as long as he wants, but the end is becoming visible,” he told The New York Times.  “At some point, investors are going to say these companies are too big a risk to buy their debt, and that precipitates a self-fulfilling prophesy that ends up with the government having to step in.” 

Fannie and Freddie have lost a combined total of $14 billion in the past four quarters and are expected to post additional losses into next year as delinquencies and foreclosures continue to rise.  Analysts are concerned about those potential losses, but they are more concerned in the near-term about the increased borrowing costs the GSEs are facing as investors add a risk premium to their bonds. 

Those rising costs translate directly into higher mortgage rates for home buyers, creating an additional drag on home sales. Conventional fixed-rate mortgages are currently averaging around 6.6 percent, which is about where they were this time last year.  “But if investors weren’t so nervous, rates would be about a percentage point lower, based on historical comparisons,” a recent CNN Money article noted.

As Fannie and Freddie continue to struggle with their own financial demons, they have been unable to play the central role legislators and policy makers had anticipated in the government-backed efforts to help struggling borrowers avoid foreclosure.  Both companies have increased the fees they charge lenders and tightened their standards for the loans they purchase; Fannie announced recently that it will cease purchasing Alt-A loans entirely. 

Bad News for Housing

None of this represents good news for a housing market that continues to sag under the weight of declining prices, anemic sales and bulging inventories of unsold homes. 

New home sales hit a 17-year low in July, falling to an annual rate of 965,000 units, reflecting the negative impact of tight credit and inventories further bloated by bank foreclosure sales.  Builders broke ground on 30 percent fewer homes in July than in the same month last year and permits, an indicator of future construction activity, fell by 18 percent

The National Association of Home Builders (NAHBB) managed to find something of a silver lining in those clouds, contending that the negative numbers reflect successful efforts by builders to curb new construction, “which slowly but surely [will help] to bring supply and demand back into balance and put us on the road to a much healthier housing market,” NAHB President Sandy Dunn said in a press statement.

“While there  is definitely a sense that we are  nearing the bottom of the downswing in home sales,” David Seiders, the association’s chief economist, added, “builders are not ready to start ratcheting up production just yet, nor should they be,” he said, “until after sales begin to rebound and the inventory overhang is reduced further.” 

Glimmers of Hope?

There are some signs that is beginning to happen in some markets.  Inventory levels declined slightly in July in 29 markets, according to ZipRealty, Inc., with the supply of unsold homes falling by nearly 4 percent in 18 of the metropolitan areas the company tracks.  Still, the 4.5 million homes for sale nationwide represented an 11-month supply at the current sales pace, nearly double the measure (six months) viewed as a healthy balance between buyers and sellers.

Existing home sales also fell again in May and June as did home prices, which were 15.8 percent below the year-ago level in May, according to the closely-watched S&P Case-Shiller Home Price Index.  On a more hopeful note, pending home sales, as calculated by the National Association of Realtors (NRA) rose slightly in June, suggesting that falling prices may finally be luring reluctant buyers who have been stuck at pool-side to re-enter the housing waters. 

“Although foreclosures are up, there seems to be enough of a price decline that buyers are starting to look for bargain and they’re willing to purchase,” John Silvia, chief economist at Wachovia Corp., told Bloomberg News. 

The NAR’s chief economist, Lawrence Yun, is also encouraged by the recent I uptick in pending sales, which indicates that returning buyers “may have put a floor on prices,“ Yun noted hopefully in a recent press release.  Another positive trend, in his view:  the 5.3 percent (June over May) increase in pending sales “was broad-based, with all four regions of the country showing gains.” 

The $7,500 tax credit for first-time home buyers, included in the new federal housing assistance legislation, should provide another welcome boost to the housing market, Yun said, spurring sales momentum later this year that, he predicts, “could carry into 2009.”