Even with the recent Freddie Mac announcement that the Office of Federal Housing Enterprise Oversight (OFHEO) is imposing a higher statutory minimum capital requirement, the GSE's portfolio growth is not expected to significantly slow in the near term, analysts said.

OFHEO is now telling Freddie Mac to come up with $32.6 billion in core capital - which is equivalent to a 30% minimum in capital reserves - during the period prior to the time Freddie is able to release certified financial statements for 2003.

Kevin Jackson, vice president and senior mortgage strategist at RBC Dain Rauscher, said that Freddie (whom Jackson called the second largest U.S. mortgage buyer) must now set aside 2.5% of on-balance sheet assets and 0.45% of off-balance sheet assets.

He noted that Freddie already has $33.2 billion on reserve, which more than complies with the new directive. Since the current surplus is already over the new capital requirement ($32.6 billion), Jackson does not believe that it would have a considerable effect on the GSE's growth prospects. However, if mortgage-to-debt spreads were to widen, Freddie's ability to grow at an accelerated rate could be affected.

Meanwhile, other market observers concur. "Because the 30% capital addendum is only temporary, it will not necessarily significantly slow Freddie Mac's portfolio growth in the near term," said a Citigroup Global Markets report. However, Citigroup also said that should this higher capital standard stay in place for an extended period, slower portfolio growth and less supply will probably boost agency debt relative to Libor.

Citi also said that many investors are worried that a higher capital requirement for Freddie, though temporary, could result in the agencies becoming less effective as a "backstop" for the mortgage sector. Analysts tried to allay these fears by saying that investors must note that the capital rule should only be in place for over a year. Aside from this, Citi said that if mortgages cheapen considerably against agency debt, rival Fannie Mae would likely up its purchases enough so that the mortgage market wouldn't have to suffer too much.

Freddie previously announced that it would retain the $5 billion of additional capital coming from its upward earnings restatement on its balance sheet at least up to the time its accounting becomes current. Thus, Citi said that Freddie might not need to issue subordinated debt in 2004. With the new OFHEO requirement, Freddie must now hold this surplus capital on its balance sheet. This is why Citi's outlook for subordinated debt issuance and performance is still the same. Furthermore, at the margin, the new temporary capital requirement should improve the way the credit quality of Freddie's debt securities are viewed, analysts wrote.

Equity and mortgage markets affected differently

In a separate report, Bear Stearns said that the new OFHEO rule should hinder Freddie from leveraging the extra 30% capital through portfolio growth.

"The mortgage market may consider that old news since the Freddie portfolio shrank by $11 billion in the last two months of 2003," analysts at Bear wrote. "But the equity markets must have learned something." They noted that Freddie stock closed down 0.61% on the day of the OFHEO announcement. At the same time, Fannie's stock increased 0.33%.

OFHEO's action might force Freddie to preserve a piece of capital that will probably be quite sensitive to changes in the swaps and swaptions markets, said Bear Stearns. The firm also noted the GSE's extra capital appeared in November after Freddie restated its financial results from the first quarter of 2000 to the third quarter of 2003. Analysts said that the most crucial portion of the restatement was the marking of Freddie's derivatives hedges to fair value, which favored the agency as interest rates dropped and implied volatility increased in the last few years. Under current U.S. GAAP, Freddie is not required to mark these hedges to fair value.

As a result, the new capital level might be more of a reflection of an accounting opinion, than a mark-to-market, analysts explained.

"If most of the extra 30% of capital came from gains in its hedges, then Freddie Mac now finds itself having to hedge the gains in its hedge - something with great value under GAAP but little value under real portfolio economics," Bear wrote, adding that this becomes a distraction from the already difficult task of looking for profitable investments.

A senior mortgage market observer said that the 30% increase might mean that Freddie from now on has to be cautious in growing its portfolio, which might be a negative for Freddie's stock but not for its debt.

"To the extent that they have to manage their institution with greater conservatism, that could slow earnings growth, and will also be negative for the stock," said the senior market observer. "But a more cautious portfolio strategy, if anything, would be a slight positive for the debt."

He added that the higher capital directive would not necessarily affect Freddie's market share against Fannie, as the move might negatively affect portfolio growth but not necessarily Freddie's guarantee activity.


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