Fannie and Freddie Set Free

Federal regulators have eased the lenders' capital surplus requirements, to inject some much-needed money into the mortgage market

Another stone fell into place in the federal government's plan to build a path to credit market recovery. On Mar. 19, the Office of Federal Housing Enterprise Oversight, or OFHEO, said it was reducing the amount of capital it requires Fannie Mae (FNM) and Freddie Mac (FRE) to maintain on their balance sheets above statutory requirements. By reducing the capital surplus level from 30% to 20%, the regulator will provide up to $200 billion in immediate liquidity to the distressed mortgage-backed securities market.

Investors welcomed the announcement, pushing up Fannie's share price by 8.8%, to close at 30.71, and boosting Freddie's shares by 14.9%, to 29.90.

The latest move, combined with earlier actions to loosen controls on Fannie and Freddie, should enable the two government-sponsored enterprises to buy hundreds of billions of dollars worth of mortgages. Starting Apr. 1, the mortgage limits on loans the two outfits can guarantee will rise from $417,000 to $729,750. The caps on their portfolios have also been lifted.

An Infusion of Cash

The key factor in the decision to ease capital rules on the two companies was that they reported audited financial results on time at the end of February, OFHEO's director, James Lockhart, said on CNBC Business News. With the proper risk-management and financial controls in place, "now is the time they can truly help the mortgage markets," Lockhart said.

Even though the move comes just days after the near-collapse of Bear Stearns (BSC), Lockhart said that event didn't figure into OFHEO's decision.

Investors and government officials hope that making the extra capital available to Fannie and Freddie will help restore liquidity in mortgage markets. Those markets have been paralyzed since last fall, and 30-year fixed borrowing rates on mortgages have stubbornly resisted coming down along with the Federal Reserve Board's federal funds rate. The gap between the fixed mortgage rate and the 10-year Treasury bond is currently about 265 basis points. A more typical spread would be 120 basis points, says Bill Larkin, a portfolio manager for fixed income at Cabot Money Management in Boston.

Focused on Jumbo Loans

Instead of loosening up, mortgage lenders have remained focused on preserving cash and reducing their risk. "The jumbo [mortgage] market has been closed because all these banks are in self-preservation mode," Larkin says. "They know there's not going to be a market for [these loans], so they don't want to hold those mortgages on their own books when they need the cash to save themselves."

Larkin believes allowing Fannie and Freddie to securitize and guarantee larger loans will loosen up the higher end of the market, where more wealth is concentrated. For now, institutions are staying away from jumbo loans unless they have Fannie or Freddie's name on them, he says: "It's like a seal of approval or branding. [It shows] that someone did their due diligence."

Paring the surplus requirement to 20% from 30% would free up $2.6 billion in capital for Freddie and $3.2 billion for Fannie. If that extra capital were used, Freddie could increase its mortgage portfolio by $87 billion and Fannie could expand its portfolio by $107 billion, analyst Bradley Ball said in a Citigroup (C) research note on Mar. 19. (Citigroup Global Markets does and seeks to do business with the companies covered in its research reports.)

But while the extra capital will set the jumbo markets moving again, Larkin says he doesn't expect spreads between mortgage rates and 10-year Treasuries to shrink meaningfully until the government says it will guarantee Fannie and Freddie paper. That would trigger a wave of refinancing, he believes: "You'd be creating a floor in housing. You'd be stimulating a whole bunch of new demand."

Earlier this month, though, the Treasury Dept. denied rumors that it had any intention of explicitly guaranteeing Fannie and Freddie's loans, though implicitly they are guaranteed. Such a move also would be opposed by many Republicans in Congress.