Are Investors Overreacting on Fannie, Freddie?

While MBS markets firmed following Office of Federal Housing Enterprise Oversight director James Lockhart’s insistence earlier this week that FASB’s accounting changes should not drive capital changes at either Fannie Mae (FNM) or Freddie Mac (FRE), it’s pretty clear Thursday that both the debt and equity markets are still skeptical. Interviewed on CNBC in the midst of an FDIC Forum on Mortgage Lending to Low and Moderate Income Households, the GSE regulator said that OFHEO is working with the Federal Accounting Standards Board as it continues to formulate changes to rules governing securitization accounting. If despite OFHEO’s efforts, the changes do bring guaranteed mortgages onto the GSE’s balance sheets, Lockhart said doing so “doesn’t change the risk of these firms, and it would make no sense to have a dramatic capital change,” as a result. In other words, OFHEO would use its regulatory authority to provide relief. And there are numerous historical precedents of banking and other government regulators providing capital relief to their regulated entities when accounting treatments change. Lockahart also insisted that Fannie and Freddie are adequately capitalized. FTN Financial Group analyst Jim Vogel, in a note to investors Thursday, said that the market has so far failed to grasp the full significance of Lockhart’s comments. The director of OFHEO, Vogel said, knows more about the current facts than any commentator — or as Lockhart put it, as regulator, “we’ve been in constant contact with them [Fannie and Freddie].” “[Lockhart] most likely knows what Fannie and Freddie’s earnings are (in round numbers) for 2Q,” Vogel said. “In the past, when he’s known they’ve lost big money for a quarter, he’s said that outright before earnings were released.” The Lehman Brothers Holdings Inc. (LEH) report released this week appears to inexplicably have caught most capital markets participants by surprise, although the accounting changes have been in the works since the beginning of the year in response to requests from both the Securities and Exchange Commission and the President’s Working Group On Financial Markets. With the uproar created by the Lehman report, whether deserved or not, GSE equity and debt analysts across the Street and investor shops have been scrambling with their accounting resources to come up to speed on the issues raised. It’s easy to see how the issue slipped past most analysts. The FASB resumed a dormant FAS 140 to address issues with what most market participants simply call “the Q” — a designation as a “qualified special purpose entity” allows off-balance sheet treatment of entities otherwise accounted for as “variable interest entities” (VIE) under FIN 46 (R) rules. The accounting standards group also opened a project to revise consolidation procedures for VIEs laid out in FIN 46 (R), as well. How the GSEs account for their guarantee obligations — and they do, despite a recent gloss by the Washington Post suggesting they don’t — was not on anyone’s mind when these projects began to meet last spring. The impetus for both of these projects were problems raised by servicers performing loan modifications in bulk, and by ABCP, SIVs, and CDOs, all structures that belied their off-balance sheet treatment. Unfortunately, FASB projects often start out addressing one thing, and ending up being about so much more. As one securities analyst who’s followed many accounting projects put it to HW, “These FASB folks remind me of physicists trying to come up with a unified theory of physics. Making a scope exception for the GSEs in the emerging FIN 46(R) model goes against the grain. We’re hearing FASB wants to come up with a way to avoid consolidating the GSE’s MBS and we’re also hearing no exemptions. Undoubtedly many potent policy, regulation and law makers, in addition to Lockhart, are having offline discussions about this issue with Board members and staff as often as they can get a call through. We may not know the outcome of these deliberations until the drafts are ready.” Those drafts of proposed amendments to FAS 140 and FIN 46(R) should emerge shortly. The SEC requested the guidance be available for implementation after December 2008; that means drafts must be delivered in enough time to allow a 60-day comment period and adoption. Accordingly, FASB is projecting a November 15, 2008 effective date for new transactions (existing transactions would enjoy a one-year deferral period). There is still a Plan B: ignoring MBS for the purposes of calculating risk-based capital. And there is ample precedent for regulators softening the blow of accounting changes on regulatory capital requirements, as well. Not the most recent example, but perhaps the most pertinent, came from the four federal bank and thrift regulatory agencies who issued a rule to exclude ABCP programs consolidated under FIN 46(R) from their risk-weighted asset base (See Financial Institution Letter 87-2004, July 28, 2004). Editor’s note: Linda Lowell is a 20-year ABS/MBS market veteran, and principal of Offstreet Research LLC. Disclosure: The author was long FRE, and held no other positions of interest, when this story was originally published. HW reporters and writers follow a strict disclosure policy, the first in the mortgage trade.