This should not be news to many, but the mortgage market is awful. It is not just subprime that looks messy, but the entire mortgage market is being hit hard. The nation's largest buyers of mortgages, Fannie Mae (NYSE:FNM) and Freddie Mac (NYSE:FRE), are reporting big losses in from their mortgage portfolios.
This is important because both companies are known for only having exposure to very safe mortgages. If they are struggling, it's a sign that the credit crunch problems may not be contained to just subprime. (To learn more about the crisis, see our feature Subprime Mortgage Meltdown).
Stability? Doesn't look like it.
These two companies have historically been stable and safe. Both organizations were created by the government to make it easier for citizens to get mortgages. The companies are implicitly backed by the government, and have in the past had very effective risk controls that made their portfolios stable. The stocks recently show how that sentiment had changed. In the one month from October 23 to November 23:
• Fannie Mae is down 45% from $58.27 to $32.20
• Freddie Mac is down 50% from $53.24 to $26.47
The Causes
Fannie Mae finally filed a 10Q this month after recovering from an accounting scandal, and reported net income for the first three quarters of 2007 dropped 57% to $1.5 billion compared with $3.5 billion for the same period in 2006.
While management said that they were pleased to have a 10Q out after three years of work rebuilding the company and its image, they stated the results "arrive in the midst of one of the most challenging mortgage and housing markets in recent history". Now that there is a current picture of the company's results, it's just not pretty. Fannie reported a net loss of $1.5 billion or $1.56 per share for the third quarter, which has brought net income down to $1.17 per share for the first three quarters of 2007. What will happen in the fourth quarter? It could be a surprising recovery or further write-downs, potentially causing a year-end loss. A recovery in current conditions would be very surprising.
Freddie Mac is not faring well either. The company reported a $2 billion loss for the third quarter. Along with this, it is considering cutting its fourth quarter dividend in half and selling mortgage assets to raise capital. This may be what Freddie's management has to do, but it is just bad news piled on top of bad news. Cutting the dividend causes the market to completely revalue the company, and this is a nasty market to sell into. Both companies may need to raise capital to sustain themselves, Fannie acted first floating $500 million in preferred shares. (To learn more about preferred shares, see A Primer On Preferred Stocks).
While again it may be necessary, all it is equaling is more hits to earnings. In response to all the trouble, Freddie Mac shareholders have now filed a class action lawsuit alleging the company did not have adequate risk controls in place between August 2006 and November 2007.
Things Can Be Worse
Things can, and very likely will, get worse in the mortgage markets. As reported in the Wall Street Journal, on November 24, next year $362 billion worth of subprime adjustable-rate mortgages are set to recast, according to data from Bank of America (NYSE: BAC). Realize that most of the recent rise in defaults, so far, has not been due to adjusting rates. While Fannie and Freddie don't have these, it is more bad news for the mortgage market and general market. And if this causes more dramatic pressure on the mortgage market, it will put more pressure on Fannie and Freddie's portfolios. (For more on the danger of adjustable-rate mortgages, check out American Dream Or Mortgage Nightmare?)
The other big effect has been the housing slump, which has been showing no signs of improving. Third-quarter figures from the National Association of Realtors showed that house sales declined in 46 out of the 50 states. They also reported that nationwide existing home sales were down 13.7% for the quarter to an annual rate of 5.42 million units. (To read the full press release, click here.)
It seems that the severity of the housing market, along with continued pressure on the mortgage market, will continue to hold down shares of Fannie Mae and Freddie Mac. Depending on the severity, they may be pushed even lower.
The Bottom Line
Things are just not pretty in the mortgage market, and I would steer clear of Fannie Mae and Freddie Mac. These companies seem attractive because of their the recent declines and the implicit assurance that the federal government won't let either go out of business. True, the companies won't go bankrupt, but the stocks can go lower. Until there is material improvement in the housing and mortgage markets, Fannie and Freddie will see continued trouble.
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