Capital Idea: Stronger Fannie Oversight

It's extremely rare for politicians to understand companies and markets. But when it comes to Fannie Mae (FNM - commentary - Cramer's Take), the folks on Capitol Hill have a far stronger grasp of what's going on at the mortgage giant than anyone on Wall Street. And that should unnerve anyone who has taken the stock touts at their word.

A persistent group of members of Congress, along with the Bush administration, aims to end the lax regulatory regime that Fannie Mae and Freddie Mac (FRE - commentary - Cramer's Take) operate under. Though Fannie has been lobbying hard against the establishment of a more orthodox regulatory arrangement, legislation doing just that has a good chance of becoming law within the next six months.

That should concern investors in Fannie Mae stock, since a stricter eye on Fannie's balance sheet could force the company to reduce its risk-taking and thus hit earnings growth. Under CEO Franklin Raines, Fannie has allowed the health of its balance sheet to deteriorate in a bid to achieve the earnings growth Wall Street craves.

The battle between Fannie and the promoters of a new regulator involves a number of issues. But the critical one is capital, which refers to the cushion of assets over liabilities that financial institutions hold to protect themselves against losses from bad loans or interest rate moves. As envisioned by Treasury Secretary John Snow, the new regulator would have the power to set a key capital measure called "minimum capital," currently set by statute at 2.5% of on-balance-sheet assets and 0.45% of off-balance-sheet assets.

With control over the minimum capital requirement, a regulator would have the power to lean on Fannie to reduce risk and, in dire circumstances, raise more capital. In an interview, Rep. Richard Baker (R., La.), the chairman of the House Subcommittee on Capital Markets, Insurance and Government Sponsored Enterprises, says the new regulator "should have the authority" to adjust capital requirements quickly. Baker is spearheading attempts to pass legislation that would change the way the government-sponsored entities such as Fannie and Freddie are regulated.

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In keeping with TSC's editorial policy, Peter Eavis doesn't own or short individual stocks. He also doesn't invest in hedge funds or other private investment partnerships. He welcomes your feedback and invites you to send any to [e-mail].