While mortgage giants Fannie Mae and Freddie Mac reported last week they are still drowning in red ink and dependant on taxpayer assistance to keep operating, a little-noticed change in their business practices could give taxpayers a break from the bailouts, perhaps saving about $10 billion annually, some analysts now estimate.

“It’s not chump change,” said Thomas Lawler, a housing consultant and former Fannie Mae executive.

In early February, Fannie and Freddie announced they will start purchasing hefty amounts of seriously delinquent mortgages, starting with $200 billion worth — more than a million souring loans, representing about a fifth of all past-due loans in the U.S. today. The announcements were responses to new accounting rules that allow the companies, effective Jan. 1, to avoid recording immediate losses on such buy backs.

By buying the loans, the companies will no longer have to make large payments on them to investors who control them through securities backed by the loans. Because Fannie and Freddie guaranteed the mortgages against default, they’ve been making regular payments on them to investors–even though homeowners stopped making their monthly payments to Fannie and Freddie.

“Fannie and Freddie were paying out more than they should have been to investors,” said Karen Shaw Petrou, managing director of Federal Financial Analytics, a Washington, D.C. research firm. “It’s a very sweet deal to the investors, to get Fannie and Freddie to pay them interest that isn’t actually there because the borrowers aren’t paying it.”

Analysts said the buy-backs could also boost the Obama administration’s foreclosure prevention efforts to help struggling families stay in their homes through loan modifications.

“That’s a top priority for the company,” said Freddie Mac spokesman Michael Cosgrove, speaking of the company’s ongoing modification efforts. He declined to discuss any specific plans Freddie may have for modifying any of the delinquent loans it is purchasing.

Fannie and Freddie don’t make loans themselves. Rather, they buy up millions of mortgages made by other lenders, package them into mortgage-backed securities and sell them to private investors such as hedge funds, pension funds and financial firms. The process allows lenders to receive new cash to recycle into more loans, creating liquidity for mortgage markets.

Acting like insurance companies, Fannie and Freddie also guarantee MBS investors future payments on the loans in exchange for a small slice of the homeowners’ monthly payments, usually less than 0.25% or so. Along with loans they also hold in their investment portfolios, they own or guarantee more than $5 trillion in mortgages – more than 30 million loans.

The companies made good profits until the economy started to stumble in fall 2007. By the time financial and housing markets were in full-blown crisis, Fannie and Freddie were hemorrhaging money. The government took them over in September 2008. So far, the Treasury Department has invested $111 billion in them.

But here’s how the companies hope to cut their future cash needs from Treasury:

Under the terms of their MBS deals, Fannie and Freddie can buy back “seriously delinquent” mortgages from investors at 100 cents on the dollar of the remaining unpaid principal. These are loans that homeowners haven’t made a payment on in 120 days or more, many of which are headed for foreclosure. Because they are owned and backed by the federal government, Fannie and Freddie can (and do) borrow money cheaply, including by selling short-term debt securities at interest rates of less than 1%. The companies are expected finance the loan purchases through such debt sales; once they own the loans, their guarantees will terminate, saving them future guarantee payments.

Freddie Mac reported it had 331,400 “120+ day” delinquent mortgages in MBS with unpaid principal of about $70 billion as of Dec. 31.

Fannie Mae said the unpaid principal of its 120+ day past due mortgages in MBS was $127 billion. It did not disclose the number of mortgages that figure represented. But based on recent Fannie investor reports showing that average unpaid balance on home loans it guarantees was $153,300 as of Dec. 31, Fannie could buy back approximately 800,000 mortgages.

Rajiv Setia, managing director of U.S. fixed-income research for Barclays Capital, calculated the average interest rate on these mortgages is about 6%. On $200 billion of mortgages, the interest payments guaranteed to investors would amount to about $12 billion a year. (On top of that, most homeowners also repay part of their principal in each monthly payment; Fannie and Freddie guarantee that as well.)

Laurie Goodman, head of the MBS strategy group at Amherst Securities, estimated annual interest savings to the companies – and taxpayers — of at least $8.25 billion for the first round of Fannie and Freddie purchases. She calculated the net purchases by the companies at $165 billion, rather than $200 billion, because the companies actually own some of their own MBS in their own investment portfolios — 20% for Freddie, 12.7% for Fannie—so they will buy back some bad loans from themselves.

But Goodman believes annual interest savings will grow because, as more mortgages become past due, the companies will continue to purchase delinquent loans through the year. She estimated Freddie will buy another $48 billion in such loans this year and Fannie will purchase an additional $120 billion. With these purchases, annual interest savings will jump to $10 billion or more annually, she believes.

Despite such savings, the outlook for Fannie and Freddie remains grim, even if less red. Mortgage defaults and foreclosures remain elevated in the shaky economy, with continuing high unemployment and a weak housing market. Last week, Fannie reported another quarterly loss, $15.2 billion in the fourth quarter of 2009, and requested another $15.3 in Treasury cash. Freddie reported a loss of $6.5 billion in the fourth quarter but did not request any additional Treasury funding.

Both firms warned they will need more Treasury money in the future. In releasing its 2011 budget, the Administration projected total taxpayer investments in the companies topping out at $188 billion in 2011. But some analysts project losses could be double that.

The final tab will depend in part on what Fannie and Freddie do with the million-plus delinquent loans they are buying, as well as with the hundreds of thousands of loans they are expected to buy in the future.

The companies have already set aside and reported tens of billions of dollars in “reserves” for projected losses on the loans. They are on the hook for the losses whether they own the mortgages or not because of their guarantees to investors of monthly interest and principal payments. Eventually, the companies will incur the actual cash losses on the loans.

But now that Fannie and Freddie will own so many more mortgages outright as the Administration steps up its foreclosure prevention efforts, some analysts are watching to see if they take more aggressive – i.e. more costly — steps to keep struggling homeowners in their properties, such as forgiving a portion of the principal in loans.

As government-owned firms, “they’re under enormous pressure” to help homeowners, Lawler said. “There (are) a lot of things they could do that could cost (taxpayers) more money,” said Andy Laperriere, a Washington analyst with ISI Group. But he added he “doesn’t think they are going to go much further” than current modification efforts.
A Treasury spokesperson said, “We don’t have any program changes to this effect.”

So far in the housing crisis, neither company appears to have embraced principal forgiveness as a modification tool; their public disclosures don’t cite it as an option. Meantime, more and more lenders are agreeing to forgive some principal for certain homeowners. Studies suggest principal forgiveness has become one of the most effective methods for preventing foreclosures.

Regardless, the purchase of more than a million bad loans is a significant move by two firms controlled by Uncle Sam. Two weeks ago, the Mortgage Bankers Association reported that about 10% of the 44 million mortgages it tracks – about 85% of all mortgages outstanding – were delinquent as of Dec. 31. In other words, about four million of the loans the MBA monitors are past due.

As with all delinquent loans Fannie and Freddie own or guarantee, they can modify them to help struggling homeowners; foreclose on them; or facilitate a repossession without a foreclosure (such as when a homeowner signs a deed over to a mortgage holder).

Fannie and Freddie already participate in the Administration’s main foreclosure prevention plan, the $75 billion Home Affordable Mortgage Program (HAMP: undefined, undefined, undefined%). HAMP offers applicants 90-day trial modifications – mainly a lower interest rate on a loan – and some applicants qualify for “permanent” modifications of five years. The Treasury continues to adjust and expand HAMP to increase modifications.

Through December, more than 440,000 homeowners with loans owned or guaranteed Fannie and Freddie were in trial HAMP modifications and about 10%, 43,000, had received permanent modifications.

But Fannie and Freddie have also helped tens of thousands of struggling homeowners with their own modification efforts outside of HAMP, negotiating new terms that include extending the length of a loan or temporarily reducing principal for a period. Further, last year, they approved lower monthly payments for more than four million homeowners – struggling with payments or not – who refinanced their loans at lower interest rates as rates fell in 2009.
Setia of Barclays Capital said more modifications of the loans Fannie and Freddie acquire might in fact help limit additional taxpayer investments.

“If the ‘mod’ works, it is money saved,” he said. “If it fails, the cost could be even higher than if nothing was tried in the first place. So the overall impact is unclear.”

He estimated most of the newly acquired loans will end up in foreclosure or reposed in other ways.

“Out of every 100 delinquent (loans), we think 30 qualify for ‘mods,’“ he said. “Of those that qualify, over half will fail. So in overall terms, of the original 100 loans bought out, only 10 to 15 will be successfully modified.”

Policymakers are considering what to do with Fannie and Freddie longer term. Among the options: turn them into government housing agencies; privatize them and spin them out as independent companies, or make them “public utilities” – companies with public shareholders who earn returns set by the government, which would continue to back the firms.

Last week, Treasury Secretary Timothy Geithner said the Administration would unveil it plans for Fannie and Freddie next year.

Posted in: Housing Market
Tags: delinquent loans, delinquent mortgages, fannie mae, fannie mae and freddie mac, foreclosure prevention, freddie mac