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Stricter Parenting for Freddie and Fannie

By Michael Wallace We can make them better, faster, and stronger. That, in essence, is the message from the Bush Administration to critics of government-sponsored entities (GSEs) Fannie Mae (FNM) and Freddie Mac (FRE) regarding federal oversight of those two controversial housing agencies. The critics won a partial victory after the Treasury Dept. endorsed a new regulatory body with powers commensurate with the "size, complexity, and importance of these enterprises."

Treasury Secretary John Snow unveiled the plan in a report to the House Financial Services Committee on Sept. 10. The proposal could help the unwieldy mortgage institutions recover some lost credibility with lawmakers and investors. At the same time, Snow stopped well short of severing a crucial underpinning to Freddie and Fannie's profitability and competitive standing: the implied backing by the U.S. government of their issued debt.

What brought about the Administration's shift? Years of rancor over the mandate of the housing agencies, the massive scale of their operations, and their singular influence on the home-mortgage market finally came to a head. Such GSEs were established with the simple intention of increasing the depth and liquidity of the mortgage market by packaging and securitizing mortgages for sale. The goal was noble enough: Reduce rates -- and ultimately make home ownership available to more people.

NEW REGULATOR. Alas, as Fannie and Freddie bulked up amid the home-ownership boom of recent years, critics claim that the agencies exceeded that mandate by competing against other institutions with an unfair advantage: the benefit of government subsidies, which reduced Fannie and Freddie's borrowing costs. Fannie and Freddie have been accused of siphoning profits to their shareholders that would otherwise have accrued to mortgage holders.

And some observers fear that with their leading role in the $6.6 trillion U.S. mortgage market, the GSEs operate on such a scale that the absence of tighter regulation risks destabilizing the financial markets. For members of Congress, especially agency archnemesis Rep. Richard Baker (R-La.), chairman of the House Financial Services Committee, the turbulence over accounting oversight of derivatives at Freddie Mac was the final straw (see BW Online, 6/13/03, "Why Freddie's Mess Matters").

According to Treasury's plan, supervision of the agencies would be removed from the Office of Federal Housing Enterprise Oversight and given to a new housing regulator, to be created under the Treasury's aegis. The new body would have the resources and authority "to oversee the prudential operations of the enterprises and the safety and soundness of their financial activities in order to foster liquid, efficient, competitive, and resilient national housing financial markets, including secondary mortgage markets."

DEBT-HOLDERS' ADVANTAGE. Among the key points in the Treasury's proposal: While the agencies' risk-based capital standards wouldn't be altered, the new regulator would have the authority to review the implementation of those standards. This was a sidestep by the Treasury Dept., as it appears it will not change the agencies' capital requirements but rather monitor their capital levels more closely. A paper from the International Monetary Fund had called for higher capital cushions for Fannie and Freddie, and industry groups have argued that financial leverage for GSEs should be reduced to levels on par with those of the banking and thrift community.

Other features of the plan include the full review of GSE management-information systems, risk-management processes, and professional standards. In lieu of eliminating the government subsidy, as mandated in a Senate study, the new body would sign off on all new GSE financial instruments and have the authority "to wind down any failing GSE." And while Fannie has registered under the Securities & Exchange Commission Act of 1934 -- and is required to issue financial reports in accordance with the SEC's regulations -- Freddie would also be compelled to do so in the near future.

Overall, the proposals for more appropriate regulation of the housing agencies were welcomed by the market. However, it appears that greater restriction of GSE operations will favor holders of agency debt over stockholders. The reason? More regulation and oversight of the agencies could crimp new business, putting the brakes on the rapid growth that had favored equity holders. Meanwhile, tighter capital standards would increase bondholders' margin of safety.

COMMON GROUND. Accordingly, shares of both Fannie and Freddie declined about 2% on Sept. 10 before rebounding the following day. Meanwhile, prices of agency debt rose, narrowing the yield spread of those issues over Treasuries by roughly 2 basis points. Since the Freddie Mac management shakeout in late July, agency spreads have narrowed about 25 basis points.

Though few industry insiders believe the legislation will be passed before the 2004 Presidential elections, Rep. Baker, who has been a vocal critic of Fannie and Freddie, conceded that the Treasury proposal would likely pass a House Financial Services Committee vote.

Regardless of its final shape, tighter regulation of Fannie and Freddie should help the interests of both investors and homeowners. Wall Street should be reassured by more credible oversight of the agencies, while homeowners should continue to benefit from their lower funding costs. And better supervision of the agencies should also reduce some of the ambiguity of the GSE's dual private/public purpose that has confounded many investors, while also reducing risk to the financial system from past faulty oversight. And those would be outcomes that Fannie's and Freddie's friends and foes alike could applaud. Wallace is a senior market strategist for MMS International

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