Though Federal Reserve Chairman Alan Greenspan singled out Ginnie Mae MBS last week as a possible mortgage-related purchasing option for the Fed as the supply of U.S. Treasury securities declines, market observers say that the Chairman exercised political caution by not mentioning the more likely and perhaps inevitable choice for a Treasury alternative - Fannie Mae and Freddie Mac MBS.

For more than a year, the GSEs have been deflecting criticism from Washington politicians - including Rep. Richard Baker (R-La.) and Greenspan himself - that the agencies wield too much power within the mortgage markets and present a level of risk to the economy. Despite this, however, several analysts said that Ginnie Mae bonds may not be adequate for the Fed's purposes in the long-term, and as much as the Chairman does not like to admit it, it may be inevitable that Freddie and Fannie agency debt and MBS is a much more likely candidate for Fed consumption.

According to several observers, because of the political overtones, Greenspan sidestepped the issue of purchasing Fannie and Freddie debt when he spoke last week.

"The Fed is bending over backward not to hold out the prospect that it will be dealing in agency debt," said the head of a major Street MBS desk.

"They have no other choice but to deal in the MBS of Fannie Mae and Freddie Mac," added Michael Youngblood, managing director of real estate capital markets at Banc of America Securities. "The Fed has already renewed the eligibility of MBS collateral for repo's this year, and the liquid stock of Fannie and Freddie is enormously greater than that of Ginnie Mae. They are dancing around an intractable problem that will lead to [the Fed's] regular participation in agency market debt and/or passthroughs."

In fact, as a follow-up to Greenspan's suggestion regarding the possible purchase of Ginnie Mae bonds, the Bond Market Association has started to work closely with the Fed and the Federal Reserve Bank of New York to more carefully scrutinize whether Fannie and Freddie MBS may qualify for different Federal Reserve programs.

"BMA members are now beginning to work with the Fed and Treasury Department to identify other suitable alternatives," said George Miller, deputy general counsel of the BMA. "While it is too soon to give a specific reaction to Greenspan's comments, it is clear that some securities are eligible for different aspects of [the Fed's] operations. Agency MBS may qualify for different programs."

MBS already used for repo's

Greenspan's comments last week made it clear that the Fed is seeking other instruments of monetary policy in the near future, as the supply of Treasury debt will be virtually non-existent within a few years.

"Other changes that are already allowed under current statutes could be implemented to substitute, to a limited extent, for our holdings of Treasury securities," the Fed chairman said in a speech to The Bond Market Association in White Sulphur Springs, W. Va. "For example, the Federal Reserve could purchase, outright, Ginnie Mae securities, which are fully backed by the Treasury."

The Fed maintains a $500 billion investment portfolio that it uses to manipulate interest rates. Most of that portfolio is in U.S. Treasury securities, and only a small fraction is in federal agency securities. In fact, the Federal Reserve holds only $10 million in Fannie Mae corporate debt and no Ginnie Mae MBS. The Fed has allowed its holdings of government-sponsored enterprise debt to run off, said a spokesman for the Federal Reserve Bank of New York.

Even though it does not comprise much of the Fed's permanent holdings, agency MBS has already become an integral part of the Fed's repurchase ("repo") program: In August 1999, as part of a broader preparation for possible Y2K disruptions, the New York Federal Reserve announced that it would accept Fannie Mae, Freddie Mac and Ginnie Mae MBS as collateral in repurchase transactions, making dealers more willing to hold mortgage inventories over year-end.

But Y2K is long over - and yet earlier this year the Fed quietly renewed the eligibility of all agency passthroughs for repo collateral through the end of 2001. To many analysts, this foreshadows the purchase of agency debt for the Fed's own account sometime down the road.

"Though the Fed has a political reluctance, the use of agency debt seems to already be in the cards," noted one MBS researcher. "The Fed already may be dealing with agency debt or MBS on a repo basis."

"Our experience has been positive with the eligibility of MBS for repos, so we decided to extend it for another year," said Doug Tillett, a spokesman for the New York Federal Reserve. "We will see how things continue to work. We accept GSE collateral in our repos, so you can assume that some of that is Fannie and Freddie debt. As for the Fed's own account, we don't buy variable' or more sophisticated stuff for our portfolio. In fact, our holdings of GSEs over the year have been coming off our books, and we are down to the last $10 million."

Drawbacks of GNMAs, muni's

In response to Greenspan's remarks, Ginnie Mae securities were bid up a tick or two last week, although one source mentioned that this also could have also been a result of a large bank buyer in the market.

Still, the remarks open up a debate as to which securities would be most beneficial as a Treasury alternative for the Fed.

According to BofA's Youngblood, Ginnie Maes have several drawbacks. Firstly, they are not book-eligible, which means the Fed cannot transfer them through its electronic FedWire platform. Secondly, they are nowhere as liquid as Fannie and Freddie bonds, so the Fed would not be able to transact them in size.

As for muni bonds, Youngblood noted that there is not enough issuance within this sector to give the Fed the required liquidity for even the smallest of its repurchase obligations.

"Can you imagine the political consequence of the Fed buying Texas muni's instead of another state, or buying L.A. muni's instead of San Francisco muni's?" he said.

On the other hand, Freddie and Fannie bonds do not have any of the convexity issues that Ginnie Maes have, and they behave more like Treasurys - making them a more likely fit for the Fed, according to David Montano, director of MBS research at Credit Suisse First Boston.

"But this cannot be implemented overnight," Montano said. "It is very, very difficult to get Congressional approval to allow the Fed to purchase agency debt. In the meantime, Ginnie Maes are not a bad alternative, but if that happened, it would have a huge impact on the market, and Ginnies would definitely stand out from the rest of mortgages, improving their trade immensely.

"What if there are problems with Fannie and Freddie down the road?" Montano continued. "The question here is, will the government take credit risk?"

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