With changes amuck in mortgage land, market participants are now evaluating the potential impact on the market.

Specifically, Congress is proposing to shift regulatory authority over the two GSEs - Freddie Mac and Fannie Mae - from the Office of Federal Housing Enterprise Oversight (which is part of the Department of Housing and Urban Development (HUD) ) to a new independent regulator within the Department of the Treasury.

A UBS Warburg report released last Wednesday discussed this likely regulatory shift from the OFHEO to the Treasury. "There is growing sentiment that action is necessary," said the report. "OFHEO is widely perceived as a weak regulator, stemming from its taking so long to get new capital rules in place as well as failing to detect Freddie Mac's accounting discrepancies."

UBS said that it views the transfer of authority as a win for the capital markets, for Congress and for Fannie and Freddie because it would serve to bolster public confidence in the regulator. Aside from this, UBS said that the move would make Congress seem to be taking strong action to lessen systemic risk to the capital markets. "Moreover, it allows members of Congress who have been the recipients of political contributions from Fannie and Freddie to argue that those contributions did not cloud their judgment on this critical issue," wrote UBS.

One market observer from another firm said that it was quite "odd" to have the two GSEs regulated by HUD, which has not been known for its financial expertise. "HUD serves important social purposes but financial regulation is not really HUD's strong suit."

Even the GSE's detractors think that the shift in authority would be a positive development. "We think there should be a strong regulator that understands the GSEs' business and also has the strength to deal with both their capital problems and their mission problems," said Mike House, executive director of FM Policy Focus, which is dedicated to monitoring the activities of Fannie and Freddie. He added that the Treasury Department would have more expertise than the HUD in this regard.

Implications of the changes

Despite the positive implications of the shift of authority to the Treasury department, the UBS report said that some market participants are now fearing that the Treasury might impose higher capital requirements on the two GSEs. The higher capital requirements would likely stop Fannie's and Freddie's portfolio growth. Market participants have been citing the fact that the GSEs' capital requirements are now lower than those applied to banks. This issue is important to the mortgage market because these Agencies are the biggest investors in MBS, and determine the amount of spread widening in the sector.

Other analysts and investors have explained that the GSEs have served a useful function in that they provide equilibrium to mortgage spreads as they fund themselves through buying mortgages. They were probably responsible, for instance, in saving the mortgage market back in 1998 when spreads widened out. Last month, however, there was a considerable cheapening in the mortgage market because the Agencies' debenture spreads moved in conjunction with swaps, and swaps had gapped out. The GSEs were unable to fund themselves by buying mortgages due to the lack of arbitrage. Market observers said the GSEs have also been very active in the swaps market off late to address the duration gap of their portfolio. These factors have been limiting their ability to stabilize spreads in the mortgage sector, something that might continue in the foreseeable future.

On the positive side, some investors say that increased government involvement in the capital adequacy requirement of the GSEs would likely improve the market's perception of the credit quality of Fannie and Freddie securities versus their Ginnie Mae counterparts. Ginnie Mae securities carry an explicit guaranty from the government.

Future market developments

On Sept. 10, the Secretary of Treasury John Snow will be testifying before the House Financial Services Subcommittee governing agencies in regards to the proposals to shift GSE regulatory authority to the Treasury. A report from Merrill Lynch released last Tuesday said that with the presidential elections coming up within 14 months and the economy's dependency on the housing market, it would surprising if the testimony is "terribly critical"

Meanwhile, representatives from Freddie Mac said that though it would be inappropriate for them to comment on the probable result of the legislative proposals, Freddie would always be in support of a strong and credible regulator.

Fannie Mae issued an official statement that said, "We share a goal of having a strong, respected, well-funded regulator. We have been actively engaged with policy makers on this issue in recent weeks, and based on those discussions we are very confident that a consensus will develop that is positive for the housing market, the companies and our mission."

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