With the Securities & Exchange Commission ruling that Fannie Mae's accounting did not comply with GAAP standards, analysts said that the GSE's current capital levels are probably insufficient to support its asset base.


In a recent report, Merrill Lynch noted that in late September, Fannie Mae committed to a 30% surplus above its minimum capital requirements by mid 2005. Merrill analysts estimate that Fannie's capital shortfall, without considering adverse SEC rulings, was approximately $3.7 billion. Minimum capital requirements as of August were roughly $31.3 billion, estimated core capital was about $37 billion, and target capital was $40.7 billion, according to Merrill.


Aside from this, Fannie Mae said that should the SEC ratify the Office of Federal Housing Enterprise Oversight's interpretation of SFAS133, historical earnings and capital might be subject to a hit of around $9 billion, which analysts said still stands with the yield curve roughly unchanged.


Merrill added that with the current SEC ruling, Fannie Mae might also need to raise as much as $12.7 billion by mid 2005. While roughly $4 billion of this shortfall could be achieved through retained earnings, Fannie might also need to inject about $9 billion in additional capital to maintain the size of its balance sheet, analysts explained.


Merrill also noted the uncertainty over whether the OFHEO will still require a 30% surcharge over the minimum capital requirements if Fannie Mae restates earnings as well as recognizes its SFAS133 related losses. If the surcharge are not applied -- regarded as a benign scenario -- the GSE would only be required to hold about $31.3 billion in capital by mid 2005.


However, current core capital would also be marked down to roughly $28 billion, $37 billion less than the $9 billion SFAS133 related loss. In this case, Merrill estimates that Fannie Mae's capital shortfall would be about $ 3 billion, which could be achieved through retained earnings.


Analysts do not believe this "benign" scenario is going to happen, but rather Fannie Mae would likely use a combination of balance sheet shrinkage as well as capital infusions to meet the terms of its agreement with OFHEO. Merrill added that assuming no equity infusion, Fannie Mae would shrink its balance sheet considerably, adding that for every $1 billion in capital Fannie Mae would need to raise, it will have to shrink by about $31 billion in assets, Merrill estimates.


"We are not suggesting that Fannie Mae is likely to liquidate over a quarter of its balance sheet," analysts said. "In fact, we believe massive liquidations are unlikely, given the potential for disruption in the mortgage market, and the resultant political fallout." The GSE may opt not to replace portfolio run-off, noting that liquidations have been averaging approximately $20 billion per month. This means about $100 billion to $120 billion running off in a six-month period, which translates into having to raise about $4 billion in capital.


The longer-term effect of Fannie Mae's capital constraints is probably negative for mortgage and ABS spreads in general while a positive for senior agency debt. But in the near term, with tight valuations and the potential for continued headlines and legislative risk, Merrill remains negative on the Agency/Libor basis. They also turned cautious on longer maturity Agencies in mid-November, noting that spreads remain too tight.


Analysts are less concerned about the capital situation at Fannie Mae, and more focused on the fallout in terms of specific legislative proposals that the Bush administration might consider as it once again pushes GSE reform next year.


"While we do not know the specifics of the legislation that will be considered, recent events will certainly add to the Administration's resolve to enforce market discipline on the GSE's, by chipping away at the 'implicit guarantee,'" said Merrill.


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