Did Market Overreact on Fannie, Freddie?

July 14, 2008 — -- It's a scary time throughout the mortgage industry these days, but was the sudden panic over Fannie Mae and Freddie Mac justified? It's a question some are asking as the government seeks to shore up two mortgage giants whose shares have lost half their value in recent weeks.

Former St. Louis Federal Reserve President William Poole last week said the two companies were technically insolvent. The news helped drive Fannie Mae's and Freddie Mac's stocks to dramatic lows, and their slides continued today: Fannie closed at $9.73, down from $19.51 two weeks ago -- while Freddie ended the day at $7.11, down from $16.40.

Alan Skrainka, the chief market strategist at Edward Jones, a St. Louis investment firm, said the market may have overreacted to comments made by Poole, who has been outspoken about his opposition to government-sponsored enterprises like Fannie and Freddie.

"I think the market's very nervous right now," Skrainka said. "I think they grabbed a hold of this remark, this 'technically insolvent' remark, without thinking it through."

In recent months, defaulted home loans have forced the companies to post a combined loss of $11 billion.

But Art Hogan, the chief market analyst at Jefferies & Co. Inc., a New York-based investment bank, said the market has priced Fannie and Freddie at "the worst-case scenario," rather than the current one.

"I think that fear or greed always drive the market," Hogan said. "It's one or the other, and right now it's fear driving the market. ...Whether it's irrational or not is yet to be determined."

Hogan said investors were worried that the two mortgage companies -- which hold $5 trillion in mortgages, half of all the mortgage debt in the U.S. -- would eventually become exposed to so many mortgage defaults that they would run out of the capital needed to cover their losses.

Unlike many lenders, Fannie and Freddie don't buy high-risk "alt A" or subprime loans, instead preferring conservative, fixed-rate loans. But, in this economy, even those loans are at risk of default, analysts said.

"A lot of investors started extrapolating how much exposure they have," Hogan said. "They asked, 'What if 20 percent of these mortgages default. How are Fannie and Freddie going to be able to handle that?'"

Even investors who weren't initially worried, quickly caught on, exacerbating the stocks' plunges. The prevalence of electronic training in the past decade, Hogan said, helped make that happen.

It used to take as long as a month for steep drops to take hold, as traders met to make deals face-to-face. Now, it can take as little as a day, Hogan said.

"It's just picked up the pace at which we can decimate stock valuations," he said. "The herd mentality just happens a whole lot faster."

Hugh Johnson, the chairman and chief investment officer for Johnson Illington Advisors in Albany, N.Y., said that frequent trading by hedge funds and short-sellers -- those who make bets that a company will fail -- also contributed to Fannie and Freddie's speedy descent.

"The world is now becoming populated by very active traders who can make a stock go down and can make a stock go up," Johnson said. "They set in motion trends which can stir the emotions of ordinarily sensible investors."

False information could also be playing on sensible investors' emotions. The Securities and Exchange Commission said Sunday that it would investigate whether rumors were purposely being spread to manipulate stock prices.

Johnson said that the measures the government has taken to help Fannie and Freddie -- promising to lend the companies capital, if they need it -- should help calm things down.

"This does not mean they do not have problems," he said. "It only means they may have time to work through their problems in an orderly way."