Last Updated: May 16, 2008: 3:30 PM EDT
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Fannie's new watchdog

Paulson says it's time for a 'world-class' regulator, but don't expect to see action till the housing market recovers.

By Colin Barr, senior writer

(Fortune) -- Treasury Secretary Henry Paulson is talking tough, but don't expect Washington to bring Fannie Mae to heel till the housing crisis eases.

Paulson emphasized in a lunchtime speech in Washington Friday that he believes the time has come for stronger oversight of the government-sponsored mortgage investors, Fannie Mae (FNM, Fortune 500) and Freddie Mac (FRE, Fortune 500). Senators Christopher Dodd and Richard Shelby have been working on a deal that would strengthen regulation of the companies as part of a measure better known for its expanded federal mortgage-refinancing efforts.

"Fannie Mae and Freddie Mac are guaranteeing a greater share of mortgages than ever before," Paulson said. "It's never been more critical that markets have confidence in how these companies are overseen and regulated. Given their size, complexity and important role, we need to ensure that they have a regulatory structure on par with other financial institutions."

Few would argue with that notion. Both companies have posted three straight quarterly losses and recently set plans to raise billions of dollars in new capital for the second time in six months. Fannie and Freddie both have massive borrowings resting on small equity cushions, in a structure critics say could leave taxpayers footing the bill for a bailout if the housing bust leaves the companies facing bigger losses than investors now expect. With Bear Stearns (BSC, Fortune 500) having been rescued from near collapse only two months ago, worries about systemic risk aren't easy to dismiss.

But because they are playing such a large role in the government's response to the mortgage crisis, Fannie and Freddie aren't likely to face any regulatory brushback any time soon, regardless of what happens with the Dodd bill. Analyst Gary Gordon at Portales Partners in New York says the Dodd measure seems to have momentum, now that longtime Fannie-Freddie critic Shelby is apparently on board.

The Dodd bill "looks like it gives the regulator a lot of power," he says. Even so, he expects Fannie and Freddie to get a wide berth for the foreseeable future because they're operating in "wartime conditions."

Take a decision Fannie announced Friday. The company said it would reduce down-payment requirements in housing markets where prices are falling. The decision means Fannie is dropping standards it imposed just six months ago, when it understandably was trying to weed out borrowers who might quickly find their houses worth less than their mortgages as prices fall.

The about-face shows the tension between Fannie's shareholders and the firm's expanding role in ameliorating the housing bust. Investors don't like the easier down-payment standards because they increase the likelihood the company will end up on the hook for mortgages gone bad. But any action that makes mortgages easier to come by - and therefore supports house prices - is a winner in Washington nowadays.

And when it comes to making the mortgage market work, Fannie and Freddie are practically the only game in town. Private investors have fled the market for mortgage-backed securities, leaving the companies with an 80% share of recent mortgage originations, through their own portfolios and their mortgage-guarantee businesses. That's double their share five years ago, Freddie Mac said this week on its earnings call.

Critics cringe at the concentration of credit risk implied by Fannie and Freddie's expanding business. Len Blum at investment bank Westwood Capital in New York notes in a recent report that the companies have borrowed almost $20 for every dollar of equity shareholders have. If house prices fall sharply and defaults spike, shareholders could find themselves wiped out, he says.

But Fannie and Freddie note that their new business is very attractively priced, given the lack of competition in the marketplace, and say their tightened underwriting standards should keep shareholders from having to shoulder massive losses. The companies say that even in areas where they have seen big losses - such as so-called Alt-A loans made in bubble states such as Florida, California and Nevada - their portfolios are performing considerably better than those of rivals.

"Now we see access to opportunities that the portfolio hasn't seen since 1998 and the guaranty business hasn't seen since 2003," Fannie chief Daniel Mudd said last week. "The odd thing," he added, is those trends are "happening at the same time for the company, and they are both also happening at the same time as we have the other half of our lives managing the losses in the existing book."

Gordon says says the move toward a stronger regulator may mean the companies find themselves with a bit "less flexibility. But he doesn't expect to see regulators "flex their muscles" till the housing bust moves off Washington's radar screen - whenever that might be.

"Once we get to peacetime," he says, "you could see some big changes."  To top of page

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