Fannie Mae's first-ever decision to invoke its right to buy back seasoned pools of loans supporting some of its older mortgage-backed securities not only seriously disrupted the secondary mortgage market, but also handed a bandolier of ammunition to political critics who have been hounding the agency for years.

MBS market participants say Fannie's callback of more than $1.5 billion in bonds has pulled between $120 million and $130 million out of the market and into Fannie Mae portfolios, and has thrown the secondary market for higher coupon and seasoned collateral into utter disarray. "We've been at a complete standstill for the whole week because of this," said one MBS trader who wished to remain anonymous. He noted that there was almost total unwillingness for CMO desks to bid on premium highly seasoned Fannie Mae and Freddie Mac paper.

Some investors were burned because they suddenly had their MBS investments returned to them through Fannie Mae's call, and had to re-invest the money, sometimes at a loss because of lower interest rates. These players now fear that Fannie's call will not be a one-time event, and that further calls may threaten their portfolios.

Because of this, some researchers contend that the entire analytical landscape for MBS may have to change. "By exercising calls on pass-through [mortgage securities], Fannie Mae has changed both the playing field and the rules under which investors evaluate Fannie Mae pass-throughs and structured products," said Laurie Goodman, the head of mortgage research at UBS Warburg. "We expect changes in analytic systems to become a big focal point over the next few months."

"Even though the call provision has been in place for many years, to our knowledge it has rarely been exercised," wrote MBS research head Dale Westhoff at Bear Stearns. "As a result, Street models have not incorporated this feature for valuation purposes. Clearly, this must change going forward."

"If Fannie doesn't change its position and indicate that it's a one-time event, this will be something of an analytic mess," said another MBS market official.

To make matters worse, many market participants did not even know about Fannie's clean-up call until what one called "unbelievably high" prepayment speeds for the month of March were posted on Friday, April 5. "I saw that 1990-production Fannie Mae 9.5% bonds prepaid at 96 CPR. I thought to myself, This must be a mistake,'" said an MBS researcher upon examining the data.

To be sure, Fannie Mae was fully within the rules - the government-sponsored enterprise has the right to repurchase all the mortgage loans in a pool when the principal balance is less than 10% of what it was at its issue date (known as a "10% clean-up call"). Fannie Mae emphasized that this information was fully disclosed in the original prospectuses for the retired bonds.

Fannie Mae contends that it invoked its right to call the bonds because there is an administrative burden involved with maintaining small MBS pools, and it wants to make its portfolios more efficient. Additionally, the agency said that only within the last few months has it developed the technology to identify these small pools.

But the rules are somewhat confusing to market players who up until now did not have to pay attention to the fine print. Case in point: The 10% clean-up call is applicable for mortgage pools issued before May 1, 1993. For pools issued after that date, Fannie has agreed to exercise only a 1% clean-up call, which is far less threatening to investors. For pools issued after March 2002, Fannie Mae retains the option to call pools that have only one loan remaining.

One saving grace for investors is the fact that if a very seasoned pool is in the form of a real estate mortgage investment conduit (Remic), the 10% call gets reduced to a 1% call. Therefore, investors will probably convert their callable pass-through securities into Remics. Some banks are offering this service to investors at no cost, in light of the current situation.

It does not seem likely that the other agencies will follow suit. Unlike Fannie Mae, Freddie Mac does not have clean-up calls on its pass-through securities, while Ginnie Mae prospectuses indicate that pools may be terminated only when the issuer and all holders agree on an arrangement for reaching that termination.

The squabbling will not be confined to just the MBS market, however, as investors fired up about the clean-up call have begun to act politically, which is a boost to legislators that have long battled what they consider GSE abuses.

The Office of Federal Housing Enterprise Oversight, Fannie Mae's regulator, has already been inundated with letters from angry investors who lost money because of the bond buyback. Longtime foes of the GSEs, such as Representative Richard Baker (R.-La.), who has sponsored legislation over the past two years to ensure increased scrutiny and stricter oversight of Fannie and Freddie, have already used this as ammunition for their cause. Baker's office has already released an angry letter from an investor as a press release.

But perhaps the most troubling aspect of this for investors is the looming risk of further clean-up calls. While most analysts say that Fannie probably took care of the majority of small loan pools with its most recent clean-up, with improved technology it is bound to find further pools which it can pay down. For instance, the entire adjustable-rate mortgage (ARM) market, which was untouched by the latest call, is a likely target for another clean-up call.

"We expect heavy call activity on ARMs, which were not called this month," noted the MBS research team at UBS Warburg. "We also anticipate robust REMIC activity over the next few months, as investors move to convert 10% calls into 1% calls.

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