FANNIE MAE

Anyone worried that America's housing market might have further to fall will be alarmed by the news coming out of Fannie Mae, the biggest player in the U.S. mortgage market. Yesterday it reported a first quarter loss of $2.2 billion and said it would seek $6 billion of new equity to bolster its balance sheet as the deteriorating housing market extracted a heavy toll, exposing its financial fragility. This would be bad for any firm; in Fannie Mae's case, it is all the worse for being a direct product of the way the firm is regulated.

Fannie Mae has its origins in a federal government effort to revive America's collapsed housing market in the 1930s. It was set up to syndicate mortgage loans. At the time this made sense, but it no longer seems necessary. Nevertheless Fannie Mae, and its smaller sibling Freddie Mac have grown into financial behemoths, bloated by special privileges such as exemptions from the tax and capital standards applied to most banks.

High leverage, a vast loan portfolio and limp controls are a recipe for disaster that many have long believed could extend far beyond Fannie Mae itself. Although now owned by shareholders, its debt is rightly regarded by financial markets as being backed by the federal government. It could not be allowed to fail. The government would have to step in to guarantee its financial viability to avoid a seizing-up of the mortgage market. Fannie Mae is also among the most politically astute operators in Washington, well connected to Republicans and Democrats alike via its board, consulting deals and contributions. In addition, politicians fear being portrayed as enemies of home ownership.

Little wonder, then, that Washington is doing its utmost to leave no homeowner behind. And that central to this effort are Fannie Mae and Freddie Mac, enterprises that guarantee or own some $5,000 billion of U.S. mortgages and mortgage-backed securities. As battered banks have pulled back, so Fannie and Freddie have in effect become the mortgage market – their combined market share of new originations hit 76% in the fourth quarter of 2007.

Bearing such a burden carries significant costs. As well as the huge first-quarter loss, its net assets, on a fair value basis, dropped by a staggering two-thirds in the space of three months. Meanwhile, the company reckons home prices will drop by 7-9% this year, equivalent to a 12-14% fall in the Standard & Poor’s/Case-Shiller index.

All of which might make it seem odd that $30.14 billion (market cap) Fannie Mae’s stock bounced 8.91% to $30.81 on Tuesday. But, with the potential for every $1 billion of freed-up or new capital to be used to back $30 billion-$40 billion in new business, politicians smell market stability and investors smell opportunity. After all, with lending standards tightening new business should be both profitable and relatively low-risk.

The big unknown, however, is where the bottom lies in the housing market – Case-Shiller is running at negative 13%, but looks set to worsen. Even as higher quality new business comes in, the burden of earlier excesses could increase. Hopes from Washington to Wall Street are running high, but there can be no guarantee that this will be the last time Fannie has to tap the markets.