Last week, the Office of Federal Housing Enterprise Oversight announced that Fannie Mae has met its Sept. 30 deadline to reach the required 30% capital surplus target. Now the next question becomes: What will Fannie Mae do next?

David Montano, head of mortgage research at JPMorgan Securities, noted that Fannie Mae merely exceeded its capital surplus target by $752 million, suggesting a "very low probability" of portfolio growth in the near term. Montano is expecting another $15 billion portfolio decline in October to increase the GSE's capital cushion to "a more comfortable level." Additionally, Fannie Mae and Freddie Mac portfolio sizes are converging, which could have important implications for PC Gold and FNMA swaps, Montano said.

Morgan Stanley equity analyst Kenneth Posner estimates Fannie Mae's current surplus to be roughly $36.9 billion, slightly above the $35.6 billion as of the end of June. This implies about $1.5 billion in earnings in 3Q05, marginally less than Posner's forecast. But the GSE's operating earnings, Posner added, could be less than what his model suggests, since 3Q05 earnings may be influenced by such factors as the lack of amortization expenses associated with derivative losses - the recognition of which prompted the capital agreement with OFHEO to begin with.

But it is not only capital considerations keeping the GSEs away from the MBS market. RBC Dain Rauscher Vice President Kevin Jackson said that both Fannie Mae and Freddie Mac are basically OAS buyers and are usually prudent investors, so buying only picks up when the sector is cheap. The agencies closely monitor mortgage optionality, gauged primarily through OAS. However, these spreads have been widening since June and, to the extent that this is happening, the GSEs would likely not be purchasing.

Jackson also noted that, diverging from a recent trend, net fixed-rate MBS supply had increased quite a bit in September, and also had its biggest three-month gain since late 2003 to 2004 - a factor that would put further widening pressure on OAS. Moreover, tepid bank and Asian demand could cause additional OAS widening, Jackson stated.

In its most recent report, UBS analysts theorized that both Fannie Mae and Freddie Mac have been shedding agency paper to buy non-agency paper. Analysts calculated that combined Fannie Mae and Freddie Mac agency holdings have decreased by $228.6 billion - $199.7 billion for Fannie Mae and $28.9 billion for Freddie Mac. "Going forward, we expect the shift from agency to non-agency holdings to continue, albeit at a slower pace," analysts said, noting that agency mortgages have cheapened.

UBS researchers also estimated that with a 3.25% capital charge, Fannie Mae could conceivably grow its portfolio $39.7 billion per quarter or $159 billion a year, although they view this event as unlikely. However, these calculations prove that the GSE has no real need to shrink. Analysts concluded that Fannie Mae will behave more in line with rival Freddie Mac, which has expanded its portfolio by 6.5% from year-end 2004 through September. Fannie Mae's portfolio is expected to grow 5% per year going forward.

Although Fannie Mae has met its capital requirements, it remains an uncertain road ahead for the agency. Drawbacks include the long waiting time for sufficient disclosures reflecting the company's true operating earnings power and fair common equity value as well as recent published reports alleging new and pervasive accounting problems at the agency, Morgan Stanley's Posner said.

In a related report, Banc of America Securities analysts calculated Fannie Mae's third quarter balance sheet capital numbers. Researchers presented their original estimates for the quarter and compared the results to the actual numbers released by OFHEO, noting that OFHEO would not be releasing Fannie Mae's final third quarter numbers until Dec. 31. BofA analysts also said that until Fannie Mae could calculate its third quarter capital and get OFHEO's approval, it would not be prudent for the GSE to buy any additional assets.

However, Fannie Mae will not be current on its quarterly earnings report until the GSE could complete the restatement of its earnings dating back to 2001 as mandated by the Securities and Exchange Commission, which is not expected until middle of next year.

(c) 2005 Asset Securitization Report and SourceMedia, Inc. All Rights Reserved.

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