Morningstar Advisor - Spring 2008 - 57

writedown says nothing about your ability to collect the money; it just says that if you had to sell that loan today, you wouldn’t get par value for it. KK: Is it fair to say they’ve accelerated the rate at which they’ve been taking those markdowns? RP: Well, the whole accounting scheme for them has substantively changed as they’ve negotiated with OFHEO (Office of Federal Housing Enterprise Oversight) and come out of the accounting scandal that they were involved in the last couple of years. So the answer is yes. The concept that 80% of the people who bought houses in ‘06 and ‘07 are going to mail the keys back to the bank because their house price went down seems far-fetched. Richard Pzena question is, how bad is that historical balance sheet? So, we can observe a few things. One is that Fannie and Freddie typically make good loans. They make the kind of loans that you would be the least concerned about: fixed rate, with lots of money down. Their loan-tovalue ratios, even at the end of the year, were around 60%. Versus appraised value, after whatever declines we had through year-end, there was 40% equity in the homes. You’d have to have massive deterioration before there are losses in this portfolio. Second, their delinquency rate has ticked up, but these are not subprime borrowers or no-money-down borrowers. We’re talking about delinquency rates that are under 1%. They’re not 20%. Big, big difference. The history is that they’ve done a spectacular job in making credit decisions. Now, we’re in a situation where you don’t know what’s going to happen, so you have to stress test. I’ll tell you that in a stress test on credit it’s hard to drive them over the edge. The assumptions you would have to make are unbelievably extreme. KK: Such as? RP: A national home price decline of 20%, combined with an employment decline of 10%—about as bad of an environment as you could possibly imagine. I don’t think credit gets them. I think that there are capital issues that come from having to mark to market their portfolio. You know the spread widening that we talked about? While that’s a good thing theoretically for the business you’re writing today; it’s a bad thing if you had to sell any of the paper that’s already on your books. The spread widening requires an accounting writedown. That accounting First of all, we haven’t had an environment where people have gotten panicked about high-quality mortgages. So the idea that the spreads have widened this much and that you have to actually take an impairment on your balance sheet, and that the regulators then use that balance sheet to determine whether you need more capital or not—this is the risk of Fannie and Freddie. This is why nobody wants to own it. And the accounting is complicated. You look at their books, and they have fair value accounting and GAP accounting, and now Freddie introduced another accounting mechanism. KK: A lot of people who don’t own the stocks often say that they’re just too opaque; it’s not even a question of being complicated. RP: The businesses are unbelievably simple. The accounting is complex. I wouldn’t say opaque. The business is not opaque. They charge a guarantee fee, and if somebody defaults on their mortgage, they pay for it. That’s the business. It’s not that hard. They tell you exactly what their fees are. Every quarter, you know what their fees are, and every quarter, you know how much is delinquent. What else is there to know? KK: Has your estimate value for Freddie and Fannie changed at all? MorningstarAdvisor.com 57

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Morningstar Advisor - Spring 2008

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