Even in the current Era of Large Numbers, the third quarter "earnings" reports for Fannie Mae and Freddie Mac were shockingly bad.

The two firms combined have lost a total of $54.2 billion dollars. The bulk of the losses ($17 billion for Fannie alone) were attributable to writing-off deferred tax assets, but the GSEs also reported huge increases in "credit-related expenses."

Freddie Mac's loss gave it a net worth of negative $13.8 billion, forcing it to request assistance from the Treasury to avoid triggering a move into receivership. Fannie Mae is likely to follow, possibly by the end of the year.

This disastrous turn means that receivership is ultimately likely for both firms, as the $100 billion allocated under last summer's legislation will probably prove insufficient. Nonetheless, my view is that government-sponsored enterprises, in some form, remain critically important to the real estate and financial markets. The market for securitized mortgages remains vital to the U.S. mortgage markets, as they have grown too large to be supported solely by bank portfolio lending. A simple set of calculations highlights the problem the capital-constrained banking system will have in supplying adequate credit for the home-purchase market. Assume that total annual home sales (new and existing) remain at around five million units, the average home price is around $220,000, and loans average an 80% LTV. The resulting $880 billion in new lending would require roughly $53 billion in incremental capital. Banks' natural reluctance to put 30-year fixed-rate loans in their portfolios is also a factor, as these assets create the type of asset/liability mismatch that thrifts have always struggled with.

Therefore, recovery in the MBS markets (i.e., the "loans-to-bonds" model of asset-based lending, resulting in the assets being sold into the capital markets) is essential to the U.S. real estate markets, and the economy as a whole. Given the current massive market dislocations, it's increasingly impossible to imagine a functioning MBS sector without some form of government sponsorship. Agency MBS are presently the only instrument providing liquidity to mortgage lenders, and the extremely discounted values for even super-senior prime passthroughs (currently quoted around thirty points behind Fannies) means that there is no functioning non-agency MBS market. Without the liquidity and pricing transparency of the TBA markets, the MBS sector will simply wither.

It is also unlikely that the GSEs' current role can be assumed solely by Ginnie Mae. As the Federal Housing Administration (FHA) is the only entity capable of facilitating affordable housing, the role of pooling and distributing FHA (and VA) loans will be more than sufficient for Ginnie, given its limited resources and (necessarily) rigid procedures. The GSEs' quasi-private structure also gives them flexibility to engage in activities that could ultimately help resuscitate the MBS sector and support the mortgage and housing markets. In addition to utilizing their ability to hold assets in portfolio, for example, they might eventually offer some form of credit insurance for private-label deals that meet their criteria, in exchange for fees paid to the Treasury.

It is clear, however, that all the GSEs' activities will (and should) be tightly regulated, in order to avoid a replay of the current fiasco. Clear standards must be created for loans guaranteed by the successor entities, and the nature of the government's backing for the firms must be clearly outlined; with 10-year debentures trading at more than 130 basis points over swaps, the illusion of "implied backing" clearly doesn't suffice for investors any more. The best outcome may be for recapitalized enterprises to emerge from receivership with clear operational and financial guidelines.

Bill Berliner is a financial consultant based in Southern California. His e-mail address is bill@berlinerconsulting.net

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

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