Fannie, Freddie Can't Do More

Their top executives have since been replaced, but the two government-sponsored entities, Fannie Mae and Freddie Mac , are still not up to date in their financial reporting, and many "safety and soundness issues" remain unresolved at both companies, according to federal regulators.

But that hasn't stopped Fannie and Freddie from saying they could help clean up the mortgage mess.

Their top executives, with support from the mortgage industry, are prodding lawmakers to loosen restrictions on the size of their lending portfolios and grant them access to the so-called jumbo mortgage market.

Such a move could alleviate some pain for lenders and borrowers suffering a sharp downturn in the housing market. But supporters are overlooking that it would also add to a volcano of risk mounting at Fannie and Freddie that threatens to erupt someday and shake the U.S. financial system.

The portfolios of both Fannie and Freddie have grown steadily over the years thanks to the implicit backing of the federal government, which allows them to issue debt at highly favorable rates and take on more risk. Together, they own or guarantee roughly 45% of all residential mortgages, with combined loan portfolios valued at $4 trillion.

Before this summer's financial turmoil in the credit markets, Fannie and Freddie were under pressure to shrink and face tougher regulations.

After accounting scandals broke out at both companies in recent years, the Office of Federal Housing Enterprise Oversight imposed limits on the size of their retained mortgage portfolios, citing "not only credit risk but significant interest rate and operational risks," as well as "significant systems, operational, control, and risk management challenges" at both firms.

But now that Washington, D.C., has woken up to the long-festering lending problems in the U.S. housing market, the political winds have shifted.

"Fannie and Freddie's political fortunes have been reversed in a very short period of time with a big bounce upwards," says Alex Pollock, a resident fellow with the conservative think tank American Enterprise Institute. "No doubt executives at Fannie and Freddie view this as their greatest profit opportunity in years. Spreads are blown out in the jumbo loan market, so all they have to do get permission to go in and buy this stuff up cheap."

While regulators eased portfolio limits on Fannie Mae slightly last month, leading Democrats in Congress announced a plan last week to further increase the caps for both companies so they can provide refinancing options to subprime borrowers in troubled loans and buoy home prices.

They're also calling for the government to raise the jumbo loan limit in some high-cost markets around the country in hopes that the presence of government-sponsored entities in that market will inspire credit to begin flowing more freely again.

Interest rates on mortgages greater than $417,000, known as jumbo loans, spiked over the summer as an increase in mortgage defaults made investors skittish about credit quality in the massive mortgage-backed securities market. Rates held relatively steady for smaller mortgages because they conform to guidelines set by lawmakers that allow Fannie and Freddie to buy or insure them.

While the mortgage situation has undoubtedly changed in recent years, calls for the companies to take on jumbo loans stand in sharp contrast to recommendations from government officials before the latest crisis.

"We at the Federal Reserve remain concerned about the growth and magnitude of the mortgage portfolios of Fannie and Freddie, which concentrate interest rate risk and prepayment risk at these two institutions and makes our financial system dependent on their ability to manage these risks," said Federal Reserve chairman Alan Greenspan in testimony to Congress in 2005. "To fend off possible future systemic difficulties, which we assess as likely if G.S.E. expansion continues unabated, preventive actions are required sooner rather than later."

That testimony echoed similar comments from Armando Falcon, the former top regulator overseeing Fannie and Freddie who published a report detailing the "systemic risks" posed by the growth at the companies.

"The fact is that loan portfolios at Fannie and Freddie have grown 12-fold in 14 years for one reason: to generate additional profits for the companies," Falcon wrote in a Wall Street Journal editorial from 2005. "That is nonjudgmental, just a fact. Other stated purposes for the portfolios, such as enhancing the liquidity of the mortgage-backed security market and promoting affordable housing, would be no less well-served if Fannie and Freddie continued to buy mortgage products as they do today but retained much smaller portfolios."

It's not just the systemic problems at Fannie and Freddie that could cause damage if they take on jumbo loans. The housing downturn poses short-term risks to their financial health as well.

While Fannie and Freddie have so far avoided the sort of massive asset writedowns that have recently hit other financial institutions in the mortgage market, like Countrywide Financial , their financial performance is suffering from the same issues.

"People are saying the problem is just in the subprime market and Fannie and Freddie are doing great, but look at recent results from Freddie," says Josh Rosner, an independent financial services analyst with Graham Fisher & Co. "We may not have audited and full statements from them, but we certainly have a clear sense that they have not been doing well and their credit quality is deteriorating."

Freddie said its second-quarter net income dropped 45% to $764 million. Fannie didn't report its second-quarter results, but CEOs from both companies recently told Congress that their default rates were rising and adjustable rate mortgages with resets peaking in 2008 make up roughly one-fifth of their mortgage portfolios.

"I expect to see considerable and surprising levels of defaults and some problems with the valuation of their portfolios ultimately," says Rosner. "It's a dangerous game to allow them to claim a victory at this point and give them more power to expand their portfolio when the reality is, they're perfectly capable of securitizing now. I'm not sure what expanding their portfolio does other than drive more revenue to them."