Of Whipsaws and Rumors

Story Highlights:

• An analyst's report on potential changes at Fannie Mae and Freddie Mac sent their shares reeling on Monday.
• But despite the report saying these changes had almost no chance of happening, investors panicked.
• New statements from the Office of Federal Housing Enterprise Oversight (OFHEO) and Ben Bernanke confirm Fannie and Freddie are in little danger of having to comply with new regulations.

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This week has been quite a see-saw, and we aren't even through Hump Day yet—a classic whipsaw. The big news kicking off the week was potential trouble over at Fannie and Freddie, traditionally (and perhaps unfairly) thought of as safe stalwarts.

Mortgage Giants Take Beating on Fears Over Loan Defaults
By James R. Hagerty and Serena Ng, The Wall Street Journal
https://online.wsj.com/article/SB121547387567934027.html?mod=hps_us_whats_news

Monday's slide simply followed the previous week's fears that more banks would need to raise capital in an already tight market. In addition, headlines warned credit tightening would be worse than expected and Financials' Q2 earnings would be dismal. So a report published Monday speculating an accounting rule change could possibly require Fannie Mae and Freddie Mac to raise billions of dollars in new capital sent Financials reeling once again.

Under current capital requirements, Fannie and Freddie keep some of their mortgage-backed securities (MBS) off balance sheet, giving them both plenty of excess capital. Changed rules would require all MBS be brought on balance sheet. With MBS markets still fairly illiquid currently and the instruments themselves still hard to value, Fannie and Freddie would have to scramble to meet the new minimum capital requirements under the new regulations—which is likely what had folks spooked.

Fannie and Freddie, both government-sponsored enterprises (GSE), are the largest funders of US home mortgages. If they can't fund new loans, folks fear the "credit crunch" could reach new depths. And, if the credit market tightens and Fannie and Freddie can't raise capital, folks fear they'd require a government bailout—with taxpayers footing the bill. Hence, Monday's big drop.

So what explains Tuesday's rebound? Fannie and Freddie's gains Tuesday about wiped out Monday's loss. Did investors take some time to read the analyst report and find such a change was unlikely to take place, and if it did, it likely wouldn't impact Freddie and Fannie? Who knows—Tuesday's big positive move is no more predictive than Monday's big drop.

But a longer perspective shows the panic surrounding Fannie and Freddie is undeserved. Tuesday morning, the Office of Federal Housing Enterprise Oversight (OFHEO), Fannie and Freddie's main regulator, indicated accounting changes shouldn't drive capital requirements and confirmed both remain well-capitalized. Ben Bernanke echoed the OFHEO's sentiment, adding Fannie and Freddie should be "able to serve their function of increasing access to mortgage credit, without posing undue risks to the financial system or the taxpayer." In other words, GSEs will likely be exempted from the changed rules, Fannie and Freddie will continue to remain well-capitalized and taxpayers won't be on the hook for a bailout. (At least not for Freddie and Fannie. Who knows what other "bailout" Congress may cook up.)

This is a classic whipsaw, nothing more. Sentiment moves fast, particularly when fueled by a scary, though baseless, rumor. For all of Monday's angst, we're basically back where we started. This is why longer-term investors aren't impacted by these moves and learn to ignore them—whether they take place over a few days, a few weeks or even a few months.