NEW YORK // Frayed nerves on Wall Street were on display on Monday after a report by Lehman Brothers intended to make a case for buying shares of America's two largest mortgage companies instead sparked concerns that a proposed change in accounting rules could jeopardize the entire financial industry.
The report on Fannie Mae and Freddie Mac, which provide crucial financing for the home lending market, sent financial stocks hurtling lower and rekindled questions over the health of the American banking sector. Questions also loomed over the two companies, whose debt is considered a safe haven for investments from emerging economies, including an estimated $25bn of Gulf funds.
"There are concerns this quarter will not be good," said Lee Delaporte, the director of research at Dreman Value Management. "People think there's going to be more bad news, more write-downs, more capital raises, more dividend cuts and more asset sales."
Offering higher rates than US government bonds, but considered almost as safe, debt issued by Freddie Mac and Fannie Mae has become a favoured destination for many of the dollar reserves pouring into central banks in countries with export surpluses.
While Gulf investors have been selling this so-called "agency debt" in recent months amid concerns that the US housing crisis may be spreading, overall foreign holdings of agency debt rose by at least $140.1bn in the first six months of this year, said Brad Setser, an economist at the Council on Foreign Relations in New York, led by purchases from Russia, China, South Korea and Japan.
Freddie Mac shares plummeted by 18 per cent and Fannie Mae by 16 per cent, sending both stocks to their lowest levels in 13 years. US bank shares, meanwhile, dropped to their lowest in more than a decade, led by Citigroup and Wachovia.
Analysts at Lehman's issued their report to inform clients that recent discussions with officials at the Financial Accounting Standards Board (FASB) had convinced them that Fannie Mae and Freddie Mac were likely to escape a proposed rules change that would force the two companies to raise their cash reserves by $75bn. Saddling Fannie Mae and Freddie Mac with this burden at a time when Washington was counting on them to pump funds into the moribund American housing market appeared so contradictory to official policy, the analysts wrote, "that we cannot imagine such an outcome occurring".
"We believe Fannie Mae and Freddie Mac will not fall under the changes that are being proposed," said Bruce Harting, a senior analyst at Lehman who co-authored the report. Left unfettered, it argued, the two would be able to grab business from ailing rivals.
A spokesman at the FASB said no officials were available to comment. The Fannie Mae spokesman Brian Faith declined to comment, but a Freddie Mac spokesman said: "The provision discussed by Lehman could have an effect on our ability to serve the housing mission."
Fannie Mae, or the Federal National Mortgage Association, was set up by the US government in the late 1930s to help Americans finance their homes and was privatised in 1968. Two years later, to provide competition, the US Congress in 1970 created Freddie Mac, the Federal Home Loan Mortgage Corporation. Neither company lends money to homeowners directly. Instead, they buy mortgages from banks, packing them into securities that are then sold to investors. By selling their loans for cash, banks reduce their exposure to defaults and can lend even more, thereby providing more money at lower interest rates to borrowers. While this practice makes owning a mortgage less risky, the subprime crisis demonstrated that it by no means eliminates risk. Neither does lending to Fannie Mae and Freddie Mac, which are not explicitly backed by the US government.
Nonetheless, their debts are considered quasi-government, meaning many investors believe there is an implicit guarantee that Washington would not allow them to default on their debt. The only real assurance Washington gives is that its regulators require Freddie Mac and Fannie Mae to hold a greater proportion of cash on hand as a provision against their assets going sour than it requires of other financial institutions.
Lehman's report focused on a proposal by the FASB to require financial institutions to include assets held in special purpose vehicles (SPVs) on their own balance sheets, and so eliminate the kind of surprises that rocked many banks as they were forced to cover losses their SPVs had suffered on mortgage-backed securities.
Applying the rule to Fannie Mae and Freddie Mac, however, would force them to consolidate a combined $3.69 trillion in mortgage-backed securities held outside the companies in SPVs on to their own books. To maintain their higher levels of capital-adequacy for, the two government-sponsored entities, or GSEs Lehman's analysts estimated that Freddie Mac would need to raise at least another $12 billion and Fannie Mae $29bn.
"It would be extremely challenging, to say the least, for the GSEs to raise this much additional capital," Mr Harting and his colleague, fellow analyst Mark DeVries, wrote, "and severely undercapitalised GSEs could possibly topple the already fragile capital markets."
* with agencies warnold@thenational.ae
