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A blog for breaking sales and neighborhood real estate news.

It has been five months since the Fed stepped in to "fix" the Bear Stearns debacle, which was warranted due to the potential systemic risks a failure of such magnitude would have on the broader markets. It has been one month since Treasury Secretary Paulson rolled out unprecedented steps to support the mortgage market. Supporting the mortgage market was basically supporting Fannie Mae and Freddie Mac, which buy loans made by banks and package them into securities that are then sold to investors worldwide. These government sponsored enterprises own or guarantee more that $5 trillion of mortgages and related securities. Both of these moves were aimed at one thing: instilling something financial institutions were in dire need of - confidence. Hopes were that these steps would provide participants in the market with the confidence needed for stabilization. These efforts, while necessary, appear to have missed the mark in some ways as with the sound of the closing bell last Friday; shares of Fannie Mae and Freddie Mac were at levels 90% below one year ago.

As defaults on home mortgages soar, Fannie and Freddie have recorded combined losses of about $14 billion in the past year. Those losses are expected to continue for at least another few quarters with some analysts projecting the companies will not return to the black until 2010 or 2011. If these institutions were a medical patient they would be in critical condition in the intensive care unit. Barclays Capital estimated that Fannie’s balance sheet has a negative value of $3 billion, while Freddie is $20 billion in the red. Baron’s estimates that, taking a mark to market approach to their assets, the negative equity approaches $100 billion. One of the functions of these GSEs that is rarely written about is the impact these enterprises have on the multifamily market through their purchases of multifamily mortgages. For our building sales market in New York, this is a vital ingredient in keeping our market somewhat stable. This is particularly true given the pending problems with regional and local lenders who have yet to face the full ramifications of having significant percentages of their risk based capital allocated to dangerously risky construction loans.

Things are going to change at Fannie and Freddie and it is likely to be soon. Even after accounting scandals that rocked the enterprises and saw some heads roll, officials at the two companies have been buoyed by their well-funded clout in Washington. That has already helped to minimize the impact of prior regulation that was too lenient. The net result is inadequate capitalization that enabled bosses and even shareholders to profit handsomely in up markets but is now taking its toll in a big way. In addition to the common stock price plummeting, Moody’s lowered preferred stock ratings for both companies to Baa3, the lowest investment-grade rating, from A1. Standard & Poor’s Ratings Services recently made a more modest cut, taking the preferred ratings to A- from AA-. This downgrading is stinging the banks and insurers that hold them. Given the uncertainty of the future of the companies, private investors have been wary of putting additional capital into them. Their current limbo state is highly problematic for the financial markets, the housing sector and the economy. This is a meaningful reason why a recapitalization is needed now. It will eliminate the uncertainty.

Fannie and Freddie have been trying to raise capital but this has not been easy. Freddie has approached private equity firms and other investors about buying new shares. But the needs it has dwarf any capital the private equity community might have. While going to the public markets, the spreads, or differences, between Fannie’s and Freddie’s debt yields and Treasury yields have widened considerably since the start of the housing crisis because of jitters about the highly leveraged companies’ stability. Last September, Fannie issued three-year debt at 0.55% over Treasury yields. Last week, it paid 1.23% over Treasuries. Freddie recently paid 1.13% over treasuries on 5-year notes which was the highest spread they have ever paid on such debt. A sudden pullback by overseas investors is largely to blame for these increasing spreads. Foreigners, mostly Asian central banks and funds, hold approximately 40% of Fannie’s and Freddie’s total debt while European investor demand has averaged about 11% and both of their appetites have waned since the beginning of August. The banks that manage the agencies’ debt issues are pulling out all the stops to ensure their success – even to the point of boosting demand artificially through deals know as "switches". In switches, an investor agrees to buy into a new issue in return for being able to sell back to the banks an equal amount of an old one, thus ensuring its net exposure does not rise.

These increases in the cost of Fannie and Freddie raising capital have been passed onto the consumer in the form of higher mortgage rates (a 30-year mortgage is now 6.52%) even with a Federal Funds Rate of 2%. Mortgage rates would have gone even higher if yields on Treasury bonds hadn’t fallen. Ten-year Treasuries now yield 3.8%, compared with about 4.6% one year ago. Intuitively, this dynamic will prolong the housing slump. The added cost to consumers is being reflected in the amount of new mortgage applications. For the week of August 8th, applications were down about 37% from a year ago, with purchase applications off 32% and refinance applications down 44%, according to the Mortgage Bankers Association. These levels are at their lowest since December 2000.

Given the problems Fannie and Freddie are facing, the Treasury Department has been wrestling with how to structure a recapitalization, should one be necessary. It seems like now is the time. The government bailout will likely see the Treasury taking one of two approaches. The first is a preferred-stock investment that allows the companies to raise more capital of their own. The second is nationalization through a common-equity injection that leaves current shareholders with nothing, and thus offers the taxpayers, who are financing the bailout, with a better deal. If taxpayers have to ante up, the only justification is to protect the larger financial system. In an interview this weekend, Jeffrey Lacker, the president of the Richmond Federal Reserve, threw his support behind the second option. He said that nationalization would probably also lead to the removal of both institutions’ managements, and undermine the cozy ties the agencies have long had with Congress. Former Fed Chairman Alan Greenspan indicated recently that Fannie and Freddie should be nationalized and then privatized in several transactions creating six or seven separate companies. It seems this is becoming more and more probable.

Investors in the multifamily properties have grown increasingly concerned about the fate of Fannie and Freddie as their involvement in the market has buoyed values and fueled new transactions. The two companies, along with Ginnie Mae, hold 35% of the mortgage debt on multifamily housing. There is seemingly no limit to the amount of multifamily mortgage product that can be sold to them. Even with the above mentioned problems, Fannie Mae announced last month that it would increase its commitment to buy loans on multifamily housing to provide additional liquidity for rental housing. Fannie said it invested $20 billion in multifamily housing in the first half of the year. That is down 25% from the first half of 2007 but the total number of transactions is down 45%, meaning they are becoming a more integral player in the market. There is good reason for their continued appetite in the multifamily sector. Delinquencies on Fannie and Freddie backed multifamily loans in the first quarter were just .09% and .04%, respectively. The GSE’s participation in the multifamily market is welcomed as market fundamentals continue to erode, albeit at a slow pace. What their appetite will be after restructuring will be a key for the sector moving forward.