Last week Treasury Secretary John Snow and Housing and Urban Development (HUD) Secretary Mel Martinez testified before the House Financial Services Committee about the proposal to increase the safety and soundness of Freddie Mac and Fannie Mae. They also reiterated the Bush Administration's support for both GSEs' housing mission.

Though the content of the testimony was mostly expected by the market - specifically the push to place Fannie and Freddie oversight to a new agency to be formed under the Department of the Treasury - shares of both GSEs along with other financials were weak on the news, said analysts.

"Despite there being no big negatives, we believe the barrage of headlines unnerved investors," said analysts from Banc of America Securities on Thursday last week. "As investors sort through the testimony, we believe that stocks will recover."

They added that the testimony finally articulated the Bush Administration's stance on Fannie and Freddie, thus laying to rest some of the worst political anxieties, which ranged from possible increased capital requirements to concerns over restrictions on business activity.

In his testimony, Snow addressed several crucial points, including his proposal to grant increased flexibility to the new regulator in adjusting the minimum capital requirements and risk based capital standards for the GSEs. The Treasury Secretary also proposed that the new authority would be able to review the activities of GSEs as well as evaluate new products. Aside from this, Snow also suggested that the administration's authority to appoint a limited number of members to the GSEs' boards be removed. He also supported a measure to compel both Fannie and Freddie to comply with the provisions of the Securities Act of 1934. This would require the GSEs to file financial disclosures with the Securities and Exchange Commission, which they are currently doing voluntarily.

Risk-based capital issue

One issue that is much talked about is the capital requirements for both GSEs. In his testimony, Snow made it apparent that he does not believe a change in the current GSE minimum or risk-based capital standards is really necessary. But he supports the proposal allowing the new regulator more flexibility to adjust capital requirements if needed in the future should the question arise. Aside from this, Snow did not include the often-talked-about five-year moratorium on making any adjustments to the risk-based capital standards.

"There is disappointment that the capital issue remains unresolved," said Mike McMahon, managing director at Sandler O'Neill & Partners, L.P. "Snow sort of walked the fine line not wanting to upset the capital markets with regard to the administration's use of the capital requirements." McMahon mentioned that this was made apparent by Snow clearly stating several times, in response to questions, that the administration was not proposing any changes to the current standards. In the final analysis, what Snow might have been doing was deferring the decision to the new regulator if and when that is enacted.

He said that the market would probably experience ongoing uncertainty going forward, while some interested parties would be lobbying publicly for higher capital standards. He noted that it is rather ironic that Fannie and Freddie had agreed in October 2000, as a part of their six-point voluntary initiative, to increase their subordinated debt capital ratio for holding MBS to 4%. The 4% ratio is consistent with what banks are required to hold currently. On the other hand, Basle II is suggesting that the ratio be reduced to 2%. At this point, while the issue of capital requirements is debated, and if Basle II is enacted in the meantime, Fannie and Freddie could find themselves having agreed to hold twice as much capital as the requirement set by Basle II.

Another element of the testimony that might have a significant impact on the mortgage market is the suggestion that the new authority should be given the power to review the activities of the GSEs as well as evaluate new products that they would focus on. One mortgage analyst said that Fannie's and Freddie's ability to engage in the business of subprime loans may well be restricted.

Fannie and Freddie response

Both GSEs released responses to the administration's testimony. Freddie Mac said that the ideas presented by both Snow and Martinez "appear on initial review to be a responsible proposal by the administration toward our shared goal of maintaining and enhancing strong, credible regulatory oversight of the housing GSEs."

Freddie also expressed its agreement with the Bush administration's view on capital, SEC registration and presidential appointees. However, Freddie showed some dissent on the matter of the new regulators powers. "Many of the Secretary's other ideas regarding new regulatory powers appear to be based on the Department's experience as a bank regulator," said Freddie's statement. "Our initial view is that, given the more limited, restrictive nature of the GSEs' charters, some of these ideas may not be appropriate or needed."

Meanwhile, Fannie Mae said that it appreciates the testimony of both secretaries and "the recognition they expressed for the important role housing plays in the economy and the role Fannie Mae plays in the housing sector."

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