Bank examiners from the Federal Reserve and the Office of the Comptroller of the Currency are looking at the books of mortgage investors Fannie Mae and Freddie Mac, a person familiar with the situation said.
The examiners are working with the two companies' main regulator, the Office of Federal Housing Enterprise Oversight, or Ofheo, this person said. This joint effort to assess the financial condition of the two government-sponsored companies was first reported by the New York Times Web site late Monday.
Fannie and Freddie face sizable losses as defaults increase and home prices fall. That has caused a plunge in their share prices over the past few weeks, though the shares have recovered somewhat in recent days. Ofheo has said that the companies' capital remains above their regulatory minimums.
And why are they being looked at? Here's why:
Fannie Mae and Freddie Mac may need to record more writedowns after they expanded their purchases of non-guaranteed subprime and Alt-A mortgage securities just as other investors fled to safer investments, their regulator said.
The value of $217 billion of the so-called non-agency securities is falling as other financial firms write down their holdings, the Office of Federal Housing Enterprise Oversight said in its annual mortgage market report. Privately issued securities backed by subprime mortgages made up 9.2 percent of the companies' combined portfolio, while Alt-A represented about 5.8 percent, Ofheo said.
By investing ``heavily'' in private-label securities in 2004 and 2005, the companies ``significantly increased their exposure to fair value losses from changes in market prices,'' Ofheo said. Structured investment vehicles and securities firms, battered by $452 billion in asset writedowns and credit losses, were invested in similar securities and have contributed to the price swings that may lead to more losses at Fannie Mae and Freddie Mac under generally accepted accounting principles.
``To the extent that those institutions recognize fair value losses on their private-label portfolios under GAAP, Fannie Mae and Freddie Mac may have to do so as well,'' the Washington-based regulator wrote in the report.
Subprime makes up 9.2% of the GSE's portfolio at a total of over $200 billion dollars. Imagine what happens when that portfolio has to be written down.
The following is pure conjecture; I have no inside knowledge of such things.
About a week and a half ago we started to hear very negative stories about the GSEs. Then we started to see news stories about how these entities needed cash and/or were in trouble. Here's what I think happened.
Sometime during the week of July 7 phone calls were made that involved Bernanke, Paulson and the heads of the GSEs. The main thrust of the calls was this: Fannie and Freddie were not doing well. Between rising delinquencies and falling home values the GSEs portfolios were in serious trouble and getting worse. Considering that subprime debt is 9.2% of GSE portfolios we now know that GSE's are getting hit really hard.
Then we started to see a whole lot of government support packages come out in the form of trial balloons. Basically, the federal government was trying to see what the best way to handle the situation would be.
Then we saw the Paulson GSE bail-out package come out:
First, as a liquidity backstop, the plan includes a temporary increase in the line of credit the GSEs have with Treasury. Treasury would determine the terms and conditions for accessing the line of credit and the amount to be drawn.
Second, to ensure the GSEs have access to sufficient capital to continue to serve their mission, the plan includes temporary authority for Treasury to purchase equity in either of the two GSEs if needed.
Use of either the line of credit or the equity investment would carry terms and conditions necessary to protect the taxpayer.
Third, to protect the financial system from systemic risk going forward, the plan strengthens the GSE regulatory reform legislation currently moving through Congress by giving the Federal Reserve a consultative role in the new GSE regulator's process for setting capital requirements and other prudential standards.
Note the breadth of this package. The Treasury would determine the terms and amount of the line of credit; but there is no mention at all of the possible amount. Secondly, the Treasury will essentially provide a floor for GSE stock by allowing the Treasury to buy GSE stock in the open market. This plan would essentially allow the Treasury department to prevent a GSE bankruptcy.
There are two possible explanations for this plan.
1.) Paulson is striking while the iron is still hot. He doesn't really need all of this money and authority relative to the GSEs, but he might as well ask for it now because he might need it in the future and Congress is in a giving mood right now. This is always a possibility with a package that involves politics.
2.) Paulson has seen the books and determined the GSEs are in serious trouble and he is trying to prevent a bankruptcy or something close to it. Personally, I think this is the real answer. the GSEs have been given way too much attention lately for this to not be the explanation.