Rescue plan could threaten GSE profit model

By Patrick Rucker and Al Yoon - Analysis

NEW YORK/WASHINGTON (Reuters) - Steps proposed by U.S. authorities to shore up Fannie Mae (FNM.N: Quote, Profile, Research, Stock Buzz) and Freddie Mac (FRE.N: Quote, Profile, Research, Stock Buzz) could keep the mortgage finance companies alive but may mean their days as reliable profit-growth machines are over.

Under the deal ironed out between policymakers and Fannie and Freddie, the Federal Reserve will have a new "consultative role" in determining how the two set their capital levels and "other prudential standards."

In the past, the profit-making engine for each company had been the income generated on portfolios of mortgage holdings which have a combined balance of more than $1.5 trillion. But if Fannie Mae and Freddie Mac get new mandates to hold larger capital reserves to protect against losses, the companies would deliver smaller returns to investors.

"Their earnings will return but at much lower return-on-equity" for shareholders, said Robert Napoli, an analyst at Piper Jaffray in Chicago. "I think they'll be forced to hold more capital than in the past."

As government-sponsored enterprises (GSEs), Fannie Mae and Freddie Mac have a federal regulator that sets their capital standards. The Office of Federal Housing Enterprise Oversight has argued for years that they need more power to demand that Fannie Mae and Freddie Mac build a bigger capital cushion.

Congress has long wrestled with the question about how best to determine capital levels and lawmakers, who must ratify the weekend emergency plan, are balking.

"I'm just uneasy with what we are trying to achieve here," Senator Christopher Dodd, chairman of the Senate Banking Committee told Treasury Secretary Henry Paulson and Fed Chairman Ben Bernanke at a Tuesday hearing.

Paulson told Dodd that the regulators were "bootstrapping" the emergency provision onto existing reform legislation could cause problems. The intent of the varying measures might be at odds since some of the proposals could hamstring the housing lenders at a time when a credit crunch is hurting borrowers.