Last week Fannie Mae's board of directors said that it agreed to increase its capital reserves to maintain a 30% target surplus over the regulatory minimum as per the request of its regulatory body, the Office of Federal Housing Enterprise Oversight (OFHEO). The reserve ratio is similar to the agreement Freddie Mac had with the regulator during its earlier restatement.

Analysts said that the GSE's existing capital levels are not enough to support the asset base and reach the 30% surplus required by OFHEO. However, the GSE was given nine months to achieve the level. Merrill Lynch estimates Fannie Mae's capital deficit to be roughly $3.7 billion.

Faced with this shortfall, Fannie now has to find means of raising capital. UBS said that viable alternatives for the GSE would be to retain earnings, issue preferred stock, omit dividends or reclassify assets. Analysts said that selling Fannie securities might not be efficient in raising the capital. "If Fannie Mae sells Fannie Mae securities, it would need to unload $50 billion assets to free up each $1 billion of capital needed," theorized UBS analysts, adding that this would be quite disruptive to the markets. Although letting assets run off could be a viable alternative, it would compromise future earnings, analysts said.

In terms of the mortgage market, Fannie is expected to be an opportunistic buyer of the product going forward. UBS said that if mortgages appear marginal relative to funding, Fannie would then be reluctant to buy. However, if mortgages cheapen significantly, the GSE is still expected to provide the backstop bid. A telling example is rival Freddie, which remained an active buyer in July and August of last year when mortgages were really cheap, despite its accounting woes and additional capital requirements, analysts explained. Therefore, it seems the decision to limit the amount of purchases is more a reflection of tight mortgage spreads.

Merrill Lynch reports that it's likely that the estimated capital shortfall might be higher than expected, making balance sheet shrinkage a distinct possibility. If Fannie's portfolio does contract, analysts said, it is probably a negative for mortgage and ABS spreads and a positive for senior unsecured agency debt.

"Any potential decline in the FNM portfolio effectively reduces the demand for MBS securities on the part of the agency," analysts said, noting that in the past several months Fannie has been comparatively less active in the fixed-rate MBS sector. The firm's estimates peg Fannie purchases at $35 billion in fixed-rate MBS through June of this year or roughly $4 billion monthly. "While this is not insignificant, it is not a vast import immediately either," Merrill said.

Additionally, a less active Fannie portfolio could affect the ARM sector, considering that a third of Fannie purchases this year were ARMs, analysts said. Although this figure probably includes some ABS and floating rate CMOs, these purchases should likely include agency hybrid ARMs as well.

Merrill also noted that aside from reducing a considerable source of demand for mortgage assets, FNMA's decreased portfolio growth could lessen the backstop bid for mortgages in times of stress. "This could mean that mortgages are more vulnerable to a widening, and consequently should trade at wider spreads today as well," according to Merrill analysts.

In terms of swaps and options, analysts said that to the extent that purchases drop from current levels, hedging activity could lessen, which, in turn, could result in decreased payment on swaps and a declining interest in buying options. These factors lead to slightly tighter swap spreads and lower implied volatility. Though the mortgages are still there, the holding institutions may not hedge to the same degree as Fannie.

Additionally, the convexity trade may also be affected, as GSEs need to maintain near zero duration, necessitating the hedge out option in MBS. Although this is sometimes done through the purchase of options, there is some delta hedging that goes on as well. "If mortgages are redistributed through time to other holders who may not hedge to the same degree, it is possible that the degree of convexity hedging could decline as well," Merrill stated.

An MBS analyst from a mortgage originator added that if between now and the nine months Fannie is given to achieve its capital surplus, a Long Term Capital Management-like blowup should occur, Fannie might not be able to act as a backstop to stop spreads from gapping out like it did then. However, Fannie's current dilemma might just require a one-time earnings restatement, after which the GSE could return to its more traditional role. Furthermore, most do not believe Fannie's current accounting problem plays a huge role in its decreased participation in the fixed-rate market. "It's more of a supply issue; there is so little supply in fixed rates right now that the GSEs don't really have to be aggressive buyers," the analyst said.

Copyright 2004 Thomson Media Inc. All Rights Reserved.

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