Two weeks after an economic stimulus package expanded the role of GSEs by temporarily raising their conforming loan limits, Freddie Mac and Fannie Mae are once again confronted with significant financial concerns.

Freddie Mac reported a fourth quarter net loss of $2.5 billion on Thursday, its second consecutive major quarterly drop. In November, the GSE announced a $4.6 billion third-quarter loss, leading both Fitch Ratings and Credit Suisse to downgrade its preferred stock.

Meanwhile, Fannie Mae is facing a possible downgrade of its bank financial strength rating by Moody's Investor Service because of a record $3.55 billion fourth-quarter loss. Fannie lost $2.1 billion for all of 2007 and Moody's is forecasting the company to record "sizable losses" in the first half of this year, and possibly a net loss for 2008.

In a conference call with investors on Feb. 27, Daniel Mudd, president and chief executive officer of Fannie Mae, said its newly-released annual report "accurately portrays the most challenging market facing Fannie Mae since the housing dislocation after World War II."

Fannie Mae attributed its fourth-quarter struggles largely to $3.2 billion in fair value losses; a $2 billion increase in combined credit loss reserves due to delinquency, default and severity trends and a $600 million "other-than-temporary" impairment loss on some investments in its mortgage portfolio and liquid investment portfolio.

The major hit for Freddie Mac was "significant mark-to-market losses," according to the company. Richard Syron, Freddie Mac's chairman and chief executive officer, said the company remains "extremely cautious" this year and acknowledged that a continued weakening economy "will have a further negative effect on homeowners across the country and drive credit costs higher."

After Freddie Mac announced its massive third-quarter loss in November, the company sold $6 billion in stock and slashed its dividend by 50%. Its regulatory core capital was $37.9 billion as of Dec. 31, which was $11.4 billion in excess of its regulatory minimum capital requirement and about $3.5 billion over the 30% mandatory target capital surplus enforced by the Office of Federal Housing Enterprise Oversight (OFHEO).

OFHEO Lifts Caps

The good news for both agencies is that the OFHEO decided to lift their portfolio growth caps on March 1, which will allow the companies to infuse the moribund housing market with more capital. The GSEs have had the caps in place since 2006 when they announced roughly $11.3 billion in accounting errors.

During last Wednesday's conference call, Fannie Mae's Mudd said that despite its fourth-quarter troubles there will be "major opportunities" when the company emerges "on the other side" of the troubled waters. "The key is how well we bridge ourselves across the turbulence to what should be a promising future and healthier market," he said.

Significant to its business model for growth, Mudd continued, is the expectation that the market's demand for liquidity will provide an opportunity for Fannie Mae to grow its guaranty business and portfolio. He said the company will "protect on one hand, pursue on the other hand."

Mudd added that the company will focus on five priorities: staying long on capital; protecting its credit to stem the wave of foreclosures and delinquencies; fulfilling its charter and responding to the crisis by increasing liquidity in the market; maintaining its competitiveness and governance and most importantly delivering results to its investors.

Market participants have been saying for months that the role of the GSEs will only increase with the market dislocation. This notion was reinforced when the conforming loan limits for Fannie Mae and Freddie Mac were raised up to 125% of an area's median home price, with a maximum of $729,750. The temporary lift has been touted as a necessary dose of relief for jumbo loan borrowers in more expensive areas such as California.

Perhaps to calm the jittered nerves of market participants, Mudd said, "We are ready to begin purchasing and securitizing jumbo conforming loans and will provide as much liquidity as our balance sheet and the securitization market will allow."

Despite his optimism for brighter days ahead, Mudd also acknowledged the challenges that still remain for Fannie Mae. "We're not under any illusions here," he said. "I think we're being realistic. This is a tough environment."

(c) 2008 Asset Securitization Report and SourceMedia, Inc. All Rights Reserved.

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