Agency debt widened last week as the market learned of a draft GSE legislation proposed by Senate Banking Committee Chairman Richard Shelby, R-Ala, that may take away the GSE’s implicit government guarantee.

The draft gives a new independent regulator, which will be overseen by the chairman of the SEC, the Secretary of the Treasury, and the Secretary of the Department of Housing and Urban Development, the authority to set capital requirements and the authority to liquidate the GSEs in case of insolvency without congressional approval. According to the draft bill, a liquidation of the GSEs could take place at the expense of creditors. Tax payers would thus become senior to the debt holders. A vote on this bill is scheduled for Thursday this week.

Aside from this, under the proposed bill, the new regulatory agency for the GSEs and the Federal Home Loan Banks will be responsible for approving new products and lines of business as well as overseeing compliance with affordable housing requirements. This new agency will takeover the HUD's role as the overseer of Fannie Mae and Freddie Mac. The legislation does not change the affordable housing goals for both GSEs, but the agencies would have to give advance notice before launching a new program or line of business. Once the notice is given, the new regulator is allowed 45 days to approve or deny the request for a new program; otherwise it would be approved by default. Only 30-days of advance notice is needed to modify existing products.

A JPMorgan Securities report said that, while most market participants seem to think that this bill has a low probability of being passed, it may create considerable short-term volatility in agency debentures and mortgages. Analysts said that the passage of the bill may lead to a downgrade of GSE debt, which is probably disastrous for both the agency debenture and mortgage markets.

If short-term agency debentures widen sharply (if GSEs are placed under a negative ratings watch or downgraded), this may cause a crisis. Though this is highly unlikely, if it materializes, the damage to the market may be so severe that JPMorgan has taken off its overweight recommendation against Treasuries to shift to a tactical neutral. But analysts still recommend mortgages versus agency debentures. The latter are expected to take most of the widening. If the bill is voted down on Thursday, or the probability of passage dips to near zero, agency spreads may partly recover and mortgage spreads could snap tighter, said JPMorgan. This is why they expect a near term opportunity for a major mortgage overweight probably by the end of the week.

In a separate report released today, Bear Stearns noted the possibility of a new regulator for the GSEs having the authority to change minimum capital requirements. Higher minimum capital might hasten the return on equity for the portfolio investment business. With this GSE reform legislation on the front burner in the Senate this week, analysts said that the odds seem low for a new regulator with a complete free hand to change capital.

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