The Office of Federal Housing Enterprise Oversight is busily building a case for requiring Fannie Mae and Freddie Mac to hold more capital.
Aida Alvarez, director of the office, is telling Congress and industry groups that she expects the two government-sponsored enterprises will have to bolster their capital to meet risk-based standards that her office is designing.
In an interview, Ms. Alvarez said her office had yet to come up with a specific capital level, but reiterated that extensive research indicates "there may be a need for more capital." She added that it was important for her to speak out now because "this (process) is not about any surprises."
Last week, the regulator also hired Standard & Poor's to provide a separate assessment of the financial risks posed by the highly leveraged companies. That report, due next month, may strengthen the case for higher capital levels.
Stiffer capital requirements could result in higher mortgage rates on loans purchased by the agencies, some analysts said. "With any material increase in capital, I'd expect an increase in prices," said Gary Gordon, an analyst with PaineWebber Inc., New York.
But the agencies probably can swallow a small increase, given their high profits, said Donald S. Watson, a director at Standard & Poor's, who will be a part of the ratings team.
The agencies declined to discuss the implications of higher capital levels, but pledged to cooperate with S&P. "We are a financially strong, well-capitalized company now," said David Jeffers, vice president of corporate relations at Fannie Mae. "We intend to remain well-capitalized as judged by any reasonable standard."
Higher capital levels could affect Fannie's and Freddie's portfolio growth. Both agencies have large mortgage portfolios, against which they are required to hold 2.5% capital. Mr. Watson and others termed this "a very easy standard," and if increased, it could lead to a slowdown of portfolio growth.
Mr. Gordon said it's more likely the agencies would increase their hedges on the portfolio.
The regulator's risk-based capital standards, which would require the mortgage agencies to withstand extreme declines in housing prices and high interest rate volatility, will be sent to the Office of Management and Budget for review next spring. Once cleared, the standards will be published for comment in the Federal Register.
Meanwhile, S&P has begun to gauge the chances that the U.S. government may have to make good on the debt or other obligations of the mortgage agencies.
For bondholders, whom the market believes to be protected by the implicit government guarantees on Fannie's and Freddie's securities, the mortgage agencies automatically carry the highest rating, triple-A.
But the last time S&P rated the agencies on the risk they pose to the government, Fannie Mae earned an A-minus, Freddie Mac an A-plus. That was in 1991, and President Bush's Treasury Department, which commissioned that rating, wanted the agencies to add enough capital to boost their rating to triple-A.
While that idea was shot down, Mark Kinsey, the office's deputy director, said there was probably consensus that the agencies should be required at least to get a double-A rating.
Thus, if the ratings are unchanged, and the oversight office separately recommends higher capital levels, the two conclusions would support each other. "That's a yardstick people could use to gauge what is the appropriate amount of capital," Mr. Kinsey said.
So how are the agencies likely to be rated?
On the one hand, Fannie and Freddie have substantially larger portfolios than they did in 1990, the year covered by the 1991 rating, exposing them to losses if interest rates move sharply. It yield a lower rating.
But the agencies also hold more capital now than they did in 1990, and are using sophisticated financial models to chart and manage the interest rate risk. That would point toward a higher rating.
One obvious source of risk that S&P will examine, Mr. Watson said, is whether financial instruments such as callable debt and derivatives can sufficiently protect the agencies from becoming another savings and loan disaster. Back in the 1950's rising rates left many thrifts insolvent as they tried to fund low-rate mortgages with increasingly expensive deposits.
S&P also will be trying to quantify the potential risks of new business developments that are only on the fringes of agency business, such as the proprietary automated underwriting systems, Mr. Watson said.