Fannie and Freddie Need Another $14 Billion, but Losses May Be Slowing

By Daniel Indiviglio

Although their performance was worse in the third quarter, it had more to do with derivatives than the housing market

600 fannie mae diag REUTERS Jason Reed.jpg

Late Tuesday, U.S. taxpayers got some more bad news: Fannie Mae announced a big quarterly loss and requested another $7.8 billion from taxpayers. This comes a few days after Freddie Mac posted a big loss and needed $6 billion more from the government. These Treasury draws, which amount to nearly $14 billion, easily dwarf their second quarter cash request of $6.6 billion. As bad as this looks, it isn't really due to housing market deterioration.

The Devil's in the Derivatives

Although each company still lost plenty of money due to defaulted mortgages, their bad derivatives bets really hurt them this quarter. The firms use derivatives to hedge interest rate risk. In this case, the hedge created a sizable loss for each company as long-term interest rates declined more in the third quarter than in the second. How big were those losses? Freddie lost $4.8 billion, and Fannie lost $4.5 billion -- on derivatives alone.

Here's a brief breakdown of the companies' financial performance in the third quarter:

fannie freddie q3-2011.png

As you can see, without those massive derivatives losses, the firms wouldn't have done nearly as badly. They won't have done well, but they wouldn't have needed nearly as much money from taxpayers.

What About the Housing Market?

Of course, you can see above that these companies still had pretty significant credit losses thanks to foreclosures and guaranty losses. So how did they stack up? Here's how the firms' credit losses looked compared to a quarter and year earlier:

fan and fred credit 2011-q3.png

So actually, credit losses were worse in the third quarter than in the second, but better than a year earlier. To explain the better year-over-year tally, each company notes that foreclosures have slowed due to procedural challenges, which may lead to higher charge-offs in 2012. Fannie, however, also notes that more aggressive repurchase requests (wherein they force bad loans back to the lenders that created them) have helped to drive down charge-offs.

A clearer way to measure the health of these firms' portfolios would be to look at serious delinquencies:

fan and fred delinq 2011-q3.png

In each case, delinquencies are down significantly compared to a year earlier, but appear to be treading water from last quarter.

So the story here isn't a great one, but it could be worse. As the economy continues to move sideways, these companies aren't seeing their portfolios deteriorate much -- but they also aren't seeing them improve much. Yet home prices have stopped dropping dramatically, which should help to limit loss severity. Taxpayers aren't off the hook yet, but unless the economy clearly worsens, Fannie and Freddie's losses should begin to wane.

Image Credit: REUTERS/Jason Reed

This article available online at:

http://www.theatlantic.com/business/archive/2011/11/fannie-and-freddie-need-another-14-billion-but-losses-may-be-slowing/248186/