Although Fannie Mae was scheduled to meet its excess capital requirement set by the Office of Federal Housing Enterprise Oversight - potentially allowing the firm to slow portfolio reduction - the recent unveiling of alleged new accounting violations at the firm make the future of Fannie's mortgage holdings growth uncertain. MBS analysts see this as an additional setback for the mortgage market.

According to published reports, Fannie's improprieties include the overvaluing of assets, underreporting credit losses as well as misusing tax credits. OFHEO was the first to respond to the new allegations. The GSE regulator issued a release stating that Fannie would likely meet its September capital target deadline based on current assessments and estimates. Fannie followed up by noting in a statement that it has already disclosed the estimated impact of the "most significant" items affecting its earnings through its August 12b-25 filing with the Securities & Exchange Commission.

In a report released last week, Bear Stearns analysts reported that the additional accounting problems make Fannie Mae's portfolio growth a "wild card," adding to the list of potential negatives in the mortgage market that now include weak demand and rising 30-year supply. These factors have prompted analysts to go back to a neutral-to-negative bias on the mortgage basis.

However, other analysts have said that the headlines, although dramatic, merely reiterate the concerns that OFHEO has highlighted previously in relation to its investigation of Fannie Mae's accounting, and only directly impact Fannie stockholders.

Art Frank, head of mortgage research at Nomura Securities, said the accounting irregularities could rise to the level of fraud, without having a material impact on the GSE's capital situation. The accounting problems could potentially force Fannie to continue shrinking its portfolio for an additional month or two, speculated Frank. However, in the absence of legislation that would restrict Fannie's growth, it is more likely that the firm would either level off or resume the slow growth of its mortgage holdings.

"I think the headlines should affect the stock more than the agency debt or MBS," said Amin Majidi, head of MBS research at Deutsche Bank Securities, adding that the main positive for MBS is that OFHEO gave both of the GSEs clearance in terms of their excess capital requirements. In Freddie Mac's case, Majidi said the excess capital has allowed the GSE to selectively grow its portfolio. Meanwhile, in Fannie's case, the added scrutiny from the negative accounting headlines implies that Fannie might not be able to buy mortgages even at cheap levels, but it should be done shedding mortgages from its portfolio as aggressively as it has been. "It does not sound like the adjustments on Fannie's books are going to amount to a big number, Majidi said. "So, I think the excess capital issue trumps this bad news."

Even if Fannie does meet its capital requirements, there is still the specter of its exposure to rallying rates, report Credit Suisse First Boston analysts. This has come about with Fannie Mae failing to comply with FAS 133, which pertains to hedge accounting, and FAS 115. As a result, market value fluctuations on its derivatives hedges have flowed straight through into the GSE's income statement. Until Fannie re-qualifies for FAS 133 and FAS 115 accounting, or until it reduces the volume of these hedges, CSFB analysts believe that sales by the GSE that are triggered in a rallying rate environment should continue even after the OFHEO deems Fannie as adequately capitalized.

Meanwhile, Merrill Lynch agency analyst Rajiv Setia, said, "The biggest impact of this latest bout of headline risk in our view could be to reintroduce legislative pressure to enact the tough GSE legislation favored by the Administration." Although Setia considers this as a positive for GSE debt, he remains skeptical that GSE legislation could move forward by the end of this year.

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

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