The beleaguered MBS market got a reprieve from its problems last week, after Fannie Mae Chief Executive Daniel Mudd heard proposals from OFHEO Director James Lockhart and HUD Secretary Alphonso Jackson to raise the OFHEO-imposed cap on GSE portfolios and raise the conforming loan limit of $417,000 for single-family homes in the lower 48 states.
Reacting favorably to the news, the market pulled mortgage spreads tighter, on the theory that the measure would boost the ability of GSEs to support the loan market. The agencies might also offset this increase by issuing callable debt, which these GSEs hedge partly by using swaptions.
Mere speculation that the OFHEO might lift the portfolio caps on the GSEs could boost the MBS market in the short run, according to Barclays Capital analysts. However, analysts believe that this event is highly unlikely, because OFHEO would delay lifting portfolio caps until the mark to market hits for the GSEs are better understood and there is more clarity on the subprime situation.
Even though passing GSE regulatory reform into law is more of a priority, President George Bush said last Tuesday that removing GSE portfolio caps is not totally out of the question.
Some market observers remained skeptical as to whether a higher portfolio cap would be approved, because a large increase or abolition of the portfolio cap might undermine the Bush administration's position on GSE reform legislation.
If OFHEO does raise the cap, the increase would be a modest 5%, observed Art Frank, head of MBS research at Deutsche Bank Securities. At any rate, the OFHEO might not have the power to raise the current conforming limits for Fannie Mae and Freddie Mac, because such a measure might need legislative approval to be implemented. The Senate is currently reviewing a proposal to raise such caps, although it might take awhile for this proposal to get approval, because Congress is currently on a summer break. However, it is clearly within OFHEO's power to lift current GSE portfolio limits, say market observers.
The MBS market could benefit from increased GSE conforming limits in several ways, according to market players. First, with current wide spreads in the mortgage market, the GSEs will be better able to provide a bid for mortgages, said Frank. Also, raising the current $417,000 conforming limit would not clash with the GSE's mission to service middle class and lower income homeowners, argued Rep. Barney Frank's (D-Mass.). In states like Massachusetts, New York and California, for instance, raising the current conforming limit would still mean catering to middle class individuals, because residential real estate is more expensive in these markets.
Market sources said that raising the cap on GSE portfolios would probably not have much impact under current mortgage conditions. It would create a backstop of sorts if the flight-to-quality move became bad enough to provoke investors to shun agency MBS. One market source recalled the 1998 scenario when it was even hard to sell a Fannie Mae passthrough, because in their flight-to-quality, investors opted instead for U.S. Treasury bonds. At that point, the GSEs stepped in and bought passthrough certificates for their portfolios, which helped shore up the market. In addition, the purchase of loans with "alty" attributes could also lend support to that sector. Finally, they could also buy conforming-balance triple-A bonds off subprime and ARM deals that, in many cases, remain difficult to sell.
Since the GSEs don't typically buy subordinate bonds, however, increasing their portfolios would not significantly impact the most severely stressed segments of the mortgage market. "At this point, the only subordinate bonds that can be sold are those off top-tier prime collateral," an analyst observed, and noted that the GSEs can't purchase jumbo loans because of the conforming-balance limits. If demand for Alt-A subs returns, he suggested that the GSEs could buy conforming-balance senior passthroughs off conforming-balance deals, lending support to that sector. "However, that would indicate some disconnect between the pricing of the portfolio managers and the capital-market unit," he noted, since the GSEs are still insuring loans with alternative characteristics, albeit at very high g-fee levels.
It should be noted that based on their current agreements, Fannie Mae should limit its portfolio to $727 billion, with 0% growth and Freddie Mac has previously agreed to 0.5% quarterly growth from a level of 710 billion beginning June 2006. Thus, based on their current sizes of retained portfolio - FNMA, $715 billion, and Freddie Mac $703 billionn), RBS Greenwich Capital analysts estimate that Fannie Mae might have room to add $15 billion while Freddie Mac could grow by $20 billion under their present agreement.
"Clearly, raising the portfolio limit would help the mortgage market tremendously particularly the agency CMO sector, Alt-A and Jumbo markets and subprime market," RBS analysts said. "However, recent comments by Chairman Bernanke and President Bush make us less sanguine on the outcome despite statements from HUD secretary implying the contrary."
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