Two interest groups which have traditionally been on the same side in terms of the Freddie Mac/Fannie Mae debate are now on opposing ends. FM Watch and America's Community Bankers (ACB) have both written to the Basel Committee Secretariat regarding their stance on the amount of regulatory capital the agencies must hold against their investments, with ACB emerging as an ally and FM Watch as foe.

In its letter to the Basel Committee, FM Watch urges the Committee to specify that public-sector entities (PSEs) that operate as corporate ventures should be treated as corporate risk in the Accord's standardized and internal ratings-based models.

"Failing to do so would mean that Fannie Mae and Freddie Mac would continue to enjoy a privileged risk weighting as government agencies, even though they do not have an explicit government guarantee like most PSEs," said FM Watch.

The interest group also said that treating Fannie and Freddie as PSEs in terms of risk weighting would increase investors' expectations that the agencies enjoy an implicit government guarantee. This would perpetuate the "moral hazard" associated with the agencies' activities because this would cause investors not to exercise due diligence in analyzing Fannie/Freddie securities.

Citing Standard & Poors ratings, FM Watch said that the agency's triple-A rating on the GSEs' senior debt and AA- for their subordinated debt - which are akin to the ratings of the other rating agencies - reflect the government's implicit guarantee and thus "are a distortion and are not comparable to the ratings given by the agencies to other corporate enterprises."

These ratings also do not represent the true state of Freddie's and Fannie's affairs. According to FM Watch, Fannie and Freddie have debt-to-equity ratios over 30:1, which is by far more than the leverage allowed banks. "Analyzed on a true stand-alone basis, Fannie Mae and Freddie Mac would be, at best, A-rated institutions...," said FM Watch.

On the other hand, ACB said that since GSEs have an important mission in helping the development of the U.S. housing market, they should not be treated as a traditional corporation in terms of the capital risk-weighting assigned to them. In fact, the organization said that since the regulators in each country can assign a zero percent risk weighting to certain entities, it is recommending that a zero risk-weight should be applied to certain Fannie/Freddie debt.

"Given that the GSEs encourage the development of the housing market, and because they do not mirror for-profit corporations, we thought that a zero-risk weighting is appropriate in that instance," said Michael Briggs, regulatory council for ACB.

Agencies' response

"Fannie Mae's view is that we agree with S&P that like-rated institutions should have the same risk-weighting," Robert McCarson, spokesman for Fannie Mae. "Since we are rated similar to local banks and they carry a 20% risk-weighting, we should also carry a 20% risk weighting."

He said that the reality is that a higher risk weighting for Fannie and Freddie would disadvantage smaller banks because it would raise the cost of doing business and make them less competitive with the larger banks, some of which are members of FM Watch.

"It's ironic to me that on the one hand FM Watch says ignore Fannie's and Freddie's ties to the government but don't ignore the ties to government enjoyed by the banks that are members of our lobbying group," said McCarson. "They also argue for a higher risk weighting for Fannie and Freddie but don't include Federal Home Loan Banks in their argument. The FHLBs are owned by many of the banks that are members of FM Watch so it's sort of a disingenuous argument on their part."

Representatives from Freddie, on the other hand, are reserving comment.

"Until the regulators of banks propose a change, we would have nothing to add to this debate," said Douglas Robinson, director of media relations at Freddie Mac. "I think it is clear and correct to say that FM Watch has an opinion of Freddie Mac that is not favorable and their claims and reasoning should be framed within that context."

Rating agency views

The risk weighting applied could either be reached through the standardized approach or the IRB approach. The standardized approach assigns a risk weighting depending on the classification of an institution: sovereigns (0%), banks (20%) or corporates (50% for those rated triple-A and double-A).

On the other hand, a rating is reached through the IRB approach based on the expected probability of default and historical loss assumptions.

Currently, the agencies are considered like local banks, thus carrying a 20% risk weighting. Rating agencies expect that under Basel II, Fannie/Freddie would be arriving at a risk weighting that is below 20% due to the low level of loss assumptions associated with them.

"We would hope that there would be some consistency between how an exposure will be treated under the internal ratings-based approach and the more basic standardized approach," said Jim Moss, managing director at Fitch. "The overriding issue with Basel is to bring comparability to economic capital and regulatory capital."

And if results are different between the two approaches, then "Basel has failed," said Moss.

Moss says that the likelihood, however, is that the agencies would end up with a risk weighting somewhere in between 20%, which they currently have, and 0% risk weighting as a compromise.

But those who are against the GSE are rallying behind FM Watch. Bert Ely, an institutions and monetary policy consultant at Ely & Co. Inc., believes that the GSEs should be privatized and as such "they should be treated in the same way a private corporation would be.

"Depending on what their financial strength and credit rating is, they would be given the same risk weight as any private corporation."

"The real problem is the market believes that if the agencies get into trouble the government and Congress would run to their rescue and that gets to the fundamental unfairness of it all," said Ely.

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