Market, management sank loan giants

Fannie Mae and Freddie Mac were "widow and orphan stocks." They paid a solid dividend and appeared to be positioned for long-term stability and growth -- the perfect type of stock for widows, orphans and retired individuals on a limited budget.

Unfortunately, the collapse of the two mortgage giants has taken a big bite out of the portfolios of many of those shareholders. After climbing steadily through the 1990s and holding at around $60 to $70 a share during the this decade, both stocks dropped this year, collapsing to less than $1 a share this week when the federal government took control of both companies.

What happened to Freddie and Fannie? Mark Hoonsbeen, a principal with Edina-based Nicollet Investment Management, says their failure was caused by a combination of factors -- mismanagement and misguided priorities exacerbated by the subprime mortgage crisis.

Fannie Mae and Freddie Mac were created by Congress to add liquidity to the mortgage business so that more Americans could buy homes. When banks issued mortgage loans to home buyers, they would often sell those mortgages to Fannie Mae or Freddie Mac, which would reimburse the banks for most of the money they had loaned. That reimbursement gave banks additional money to write mortgages for other home buyers.

Combined, the two mortgage giants became the second-largest issuers of debt in the world behind the U.S. government.

Without Freddie and Fannie, banks would have been limited in their ability to continuously make large 15- and 30-year loans to home buyers. In other words, the companies made the American dream of owning a home a reality for millions.

The concept worked very well for several decades, but in recent years a combination of factors put Fannie and Freddie at much greater risk. A sour mortgage market and a rash of foreclosures pushed the companies over the edge.

What went wrong?

The first mistake for Fannie and Freddie, Hoonsbeen said, was a dramatic change in their business model to pump up revenue and earnings. Originally, they resold the mortgages purchased from banks to investment companies that pooled them into mortgage-backed securities and sold those securities to private investors.

"But in an effort to boost earnings, instead of selling the mortgages, they held onto the securities to raise more money," Hoonsbeen said. Their mortgage holdings ballooned to more than $20 billion in the past few years. While increasing their income, it added dramatically to their risk if homeowners started defaulting on payments.

The other problem, Hoonsbeen said, was that Congress changed their mandate to finance more mortgages from lower-income applicants. The new goals increased the percentage for low- and moderate-income applicants from 50 percent in 2004 to 56 percent in 2008; it increased the percentage for special affordable housing (for very-low-income individuals) from 20 to 27 percent, and it increased the percentage for underserved areas from 31 to 39 percent.

When defaults and foreclosures -- particularly among low-income homeowners -- began to skyrocket, Fannie and Freddie were hit hard.

With Fannie Mae and Freddie Mac financially strapped, they were unable to keep up with the demand from banks for mortgage funding, which made it much more difficult for home buyers to secure mortgages over the past year.

As defaults and foreclosures continued to pile up, the prospects for Fannie and Freddie became increasingly bleak until there was only one remedy -- a total bailout by the federal government.

The subsequent injection of $200 billion into the mortgage market made it easier for banks to obtain funding for additional mortgages. That's why mortgage rates dropped by about half a percentage point the day after the takeover.

It also added stability to mortgage-backed securities derived from Fannie Mae and Freddie Mac mortgages. The government essentially guaranteed that principal and interest payments would be made on the debt, held by foreign central banks, financial institutions, pension funds and others.

But for widows and orphans, there was a downside.

The shares are "not worthless yet, but they might be," Hoonsbeen said. "No one really knows what it would take to turn them around, because it's impossible to determine what Freddie and Fannie have in assets. Their financials are a labyrinth."

The duo's collapse came as no surprise to Hoonsbeen or to others who have followed them for decades. "For the past 20 years Congress was being told that the companies were potentially incurring liabilities that put the U.S. Treasury at a huge risk," Hoonsbeen said. But the warnings fell on deaf ears -- in part because Fannie and Freddie have the third-largest lobby group in the United States. The result is more red ink for the federal government, more angst for taxpayers, and a total collapse of the stock value for shareholders.

Gene Walden is the author of more than 20 books about business and investing. He lives in the Twin Cities. Send questions or comments to: gwalden100@comcast.net, or visit Allstarstocks.com.