by Tanta on 12/11/2007 11:08:00 AM

There have been some questions about what this means (thanks, Ramsey, for bringing it to my attention):

MCLEAN, Va., Dec. 10 /PRNewswire-FirstCall/ -- Freddie Mac (NYSE: FRE - News) announced today that the company will generally purchase mortgages that are 120 days or more delinquent from pools underlying Mortgage Participation Certificates ("PCs") when:

-- the mortgages have been modified;
-- a foreclosure sale occurs;
-- the mortgages are delinquent for 24 months;
or
-- the cost of guarantee payments to security holders, including advances
of interest at the security coupon rate, exceeds the cost of holding
the nonperforming loans in its mortgage portfolio.

Freddie Mac had generally purchased mortgages from PC pools shortly after they reach 120 days delinquency. From time to time, the company reevaluates its delinquent loan purchase practices and alters them if circumstances warrant.

Freddie Mac believes that the historical practice of purchasing loans from PC pools at 120 days does not reflect the pattern of recovery for most delinquent loans, which more often cure or prepay rather than result in foreclosure. Allowing the loans to remain in PC pools will provide a presentation of its financial results that better reflects Freddie Mac's expectations for future credit losses. Taking this action will also have the effect of reducing the company's capital costs. The expected reduction in capital costs will be partially offset by, but is expected to outweigh, greater expenses associated with delinquent loans.

Attentive readers Calculated Risk addicts will remember the big tizzy last month over Fannie Mae's presentation of its credit loss ratio, and the confusion-party in the press that it engendered. As you recall, the issue was that Fannie Mae had been exercising its option (not obligation) to buy delinquent loans out of its MBS in order to pursue workout efforts with them. Because that requires the MBS to be paid off at par, but the accounting rules require Fannie to take these loans to their portfolio at the lower of cost (par) or fair market value, and since "fair market value" right now for a delinquent loan, even one you think can be cured (made reperforming with a workout), is terrible, doing this means that Fannie booked big write-downs at the time. Fannie then backed some, but not all, of that write-down out of its credit loss ratio on the portfolio, to distinguish between true foreclosure-related charge-offs and these fair value adjustments, and uproar ensued, with Fortune's Peter Eavis implying that they were cooking the books and hiding losses.

It appears to me that Freddie Mac has decided it doesn't want to go there. It is therefore doing what, presumably, Peter Eavis wants it to do: leave the delinquent loans in the MBS pools unless and until that becomes more expensive than taking them out.

The accounting here is rather complex (which won't stop some people from having a cow over it, but I can't help that). The somewhat simplified view is this: the GSEs guarantee timely payment of principal and interest to MBS investors. They do not guarantee that investors will earn interest forever, but only as long as principal is invested. If a loan payment is not made by the borrower, either the GSE or the servicer (depending on the contract) has to advance scheduled principal and interest payments to the MBS until such time as the loan catches up (the borrower makes up the past due payments) or is foreclosed and liquidated.

The GSEs collect guarantee fees from seller/servicers (it works like servicing fees: it comes off the monthly interest payment). They also collect some other lump-sum fees when pools are settled. This is revenue to the GSEs, with a corresponding liability (to make the advances, with the risk that the advances will not be reimbursed completely at liquidation of the loan).

Therefore, when there are deliquent loans in an MBS, and the servicer is not obligated to advance for them, the GSE has a choice: it can buy the loan out of the MBS, put it into the GSE's own portfolio, and take any and all losses directly as any other investor would (and also any income). Or, it can leave the loan in the pool, while advancing the scheduled P&I to the pool investors. Only in some specific cases is the GSE obligated to take out a loan: when mortgages are modified, when the foreclosure sale occurs, or when the loan has been delinquent for 24 months or more. In other situations, it comes down to the question of which is cost-effective for the GSE: to leave it there and continue to advance, or to take it out with portfolio capital and do the fair value write-down.

Do note that if Fannie Mae had adopted this policy that Freddie has just announced--basically, that buying the loan out of the MBS will be the last rather than the first resort--it would not have shown big fair value write-downs, those would not have affected the credit loss ratio, and a big dust-up would not have occurred. There would still have been an effect on the financials, but just in a different place: in advances (coming out of G-fees received). So you either have expense (P&I advanced to bondholders) or you have expense (capital used to buy out the loans).

Insofar as everyone has been all worked up about the GSEs' capital ratios, this should be good news: they are levering investors' capital to carry delinquent loans until they can be cured (or liquidated). Insofar as investors want principal back faster, it's maybe not good news. But you can't really have it both ways.

I think it is important to understand that the GSEs are supposed to cover guarantee costs out of g-fees, not with portfolio purchases. You might have noticed that both Fannie and Freddie are increasing the g-fees and postsettlement/loan level pricing adjustments they charge seller/servicers. So they are beefing up the funds they have to cover MBS losses with. Nothing guarantees that will be enough; I don't think anybody knows right now what will be enough. But for what it's worth, I don't see this as "playing games" with capital requirements. I guess we'll have to see what Fortune Magazine thinks.