Q & A with Emily Hollis

Emily Hollis
February 5, 2008 | COMMENTS

Question: What is going on with Freddie Mac and Fannie Mae?

These two government-sponsored mortgage investors are proving more vulnerable than expected due to unprecedented foreclosures and declines in home prices. Many investors initially viewed agency debt as a substitute for Treasury securities. However, in recent months Treasury rates have drastically dropped; the two-year Treasury is yielding under 3.00 percent and agency bullet debentures are yielding 65 basis points higher. Investors are becoming concerned with these giants due to their mortgage holdings and potential write-downs. Price movement in credit derivatives offers a bleak view with rating outlooks for these titans at Baa2, eight notches below their current AAA rating status. Is a Baa2 rating likely to occur? Seriously doubtful.

The unsettled credit environment is rocking the U.S. agency debt market. FHLMC and FNMA are responsible for raising funds with which they purchase and guarantee home mortgages for the $2.7 trillion market. Just to clarify, in order to raise funds FHLMC and FNMA issue agency debentures which many credit unions own. The agencies are solely responsible for paying principal and interest on these securities. Mortgage-backed securities on the other hand, are dependent first upon the mortgages underlying the securities and second upon the ability of the agencies to pay should these mortgages default. FNMA and FHLMC (agency) mortgages are conforming; meaning they are under $417,000 in loan principal amounts and have full documentation. These mortgages are not presenting problems .

Delinquencies are prevalent in non-conforming, low (or no) documentation, sub-prime adjustable rate mortgages. The agencies' exposure to this debt arises from securities or loans which the agencies have bought from Wall Street and hold in their own portfolios, not issued themselves. FHLMC reports that they own $105.4 billion of these “non-agency” securities (accounting for 15 percent of its holdings). FNMA holds about $42.4 billion of similar securities accounting for approximately 6 percent of its mortgage holdings. Both agencies have bought sub-prime mortgage bonds to take advantage of higher yields and ironically to meet federal rules requiring them to aid in the financing of low-income borrowers.

Nearly all of the sub-prime mortgages held by the agencies are rated AAA and due to high credit enhancements, chances of the agencies ever seeing principal defaults on these mortgages are slim. The issue is marking securities to market and reflecting unrealized losses, losses that are temporary rather than permanent. Given the current severe “credit crunch,” specialists believe that the average price on these “non-agency” securities is 90 cents on the dollar. After its third-quarter loss of $2.03 billion, FHLMC only had $600 million above the minimal capital requirements and was forced to issue $6 billion of preferred shares a few weeks ago (FNMA followed with $5 billion). A 10 percent price reduction on $105.4 billion would really hurt—just do the math!

Emily Hollis is a CFA and president of ALM First Financial Advisors, LLC in Dallas, Texas. Contact Hollis at 800-752-4628 or ehollis@almfirst.com. Margot Strong, director of business development, may be reached at mstrong@almfirst.com.