Fannie Mae and Freddie Mac are up in arms over a proposed rule that could reduce investors' demand for their mortgage-backed securities, but Wall Street and private mortgage-backed issuers favor it.

The rule, drafted last fall by the Federal Financial Institutions Examination Council, the umbrella group for banking and thrift regulators, would cut by more than half the amount of capital banks must hold against private-label mortgage-backed securities, or MBS, that are rated AA-minus or higher.

The privately issued bonds would be risk-weighted at the same level as Fannie and Freddie's securities.

Fannie and Freddie's lower risk weighting has long supplied a strong incentive to buy their securities instead of privately issued mortgage-backeds.

Comment letters sent to the examination council this month indicate widespread support for leveling the playing field - except from Fannie and Freddie.

The two government-sponsored enterprises have reason to oppose the measure. If it took effect, banks would probably lose their appetite for Fannie and Freddie bonds, experts say.

In a research note sent to clients last week, Arthur Q. Frank, head of mortgage-backed securities research at Nomura Securities International, said the changes would probably "increase bank portfolio demand for investment-grade ABS, CMBS, and private-label MBS, while reducing demand for agency MBS and GSE debt."

Under the proposal, mortgage-backeds with ratings below AA-minus would require a higher risk weighting than currently. Such a change has been discussed since 1994. It was last proposed in 1997 but put on hold when regulators realized that the Basel Committee, which is charged with setting risk-based capital standards for international banks, was at work on a draft accord addressing securitization issues.

Regulators wanted their proposal to jibe with the recommendations in the Basel draft, which was released in 1999.

Those supporting the change argue that investors have never taken a loss on AA- or AAA-rated private-label mortgage-backeds and that well-capitalized players stand behind private issues.

In contrast, this argument goes, when MBS are issued by the government-sponsored enterprises, the only thing standing behind them is the enterprise - if one believes recent affirmations by Treasury and Fannie Mae officials that the enterprises are not backed by a government guarantee against default.

The Consumer Mortgage Coalition, a trade group of mortgage lenders and servicers, and the Bond Market Association, which represents bond dealers, applauded the external ratings-based approach in separate comment letters.

In a June 15 letter, the American Bankers Association said it "supports the proposal's intention to update the standards to better reflect the risks associated with securitized transactions and to encourage better risk management."

However, each group proposed various modifications.

Fannie Mae said in a June 7 letter that, though it supports the proposal's attempt to align regulatory capital more closely with transaction risk, the rule does not account for the credit risk differences between AA and AAA securities. Fannie recommended that its own securities and AAA-rated corporate bonds be assigned lower credit risk weightings than AA-rated bonds.

Fannie also said regulators should keep in mind that private-label MBS currently require a higher risk weighting because mortgages carry higher interest rate risk. It recommended that the rule require that securities with long-duration collateral, such as fixed-rate mortgages and manufactured housing, carry higher risk weights than those with shorter-duration collateral, such as credit card debt.

Freddie Mac said in a June 7 letter that the rule would let banks "structure securitizations that reduce the capital requirements to a fraction of what they would otherwise be required to hold, even though the risk exposure remains the same." The result, according to Freddie, could be "a net reduction in the amount of capital in the banking system to protect against credit risk."

The public comment period closed June 7.

In his report, Mr. Frank said that, though the final regulation could be published as early as the fourth quarter, changes in the requirements may not take effect until next year because the effective date of bank capital requirements is commonly set several months after publication of a rule.

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