Both Fannie Mae (FNM) and Freddie Mac (FRE) may be undercapitalized relative to the market risk they are now being asked to take on, according to surprising remarks by Office of Federal Housing Enterprise Oversight director James Lockhart last week. "The legislation that created OFHEO in 1992 requires the agency to set very low minimum capital requirements and greatly limits OHFEO's flexibility with respect to risk-based capital requirements," Lockhart said in remarks at the 44th Annual Conference on Bank Structure and Competition in Chicago on Friday. "That approach, under which we operate today, has significant weaknesses." Chief among them, Lockhart suggested, were that the current legislation prevents OFHEO from establishing what he called "truly risk-based capital requirements." "OHFEO must use a stress test model that omits key Enterprise risks, including operations and basis risks," he said. The current model doesn't account for severe interest-rate stress emanating from low-rate environments, Lockhart said, nor does it account for credit stress as severe as the current downturn, he argued. The OFHEO director's remarks were the sharpest criticism yet by government officials to suggest that Fannie and Freddie will continue to face capital constraints, despite fresh capital raises from both GSEs and OFHEO's own recent decisions that have reduced prior capital surcharges. Numerous analysts, including those at UBS, have suggested in recent months that capital challenges at both GSEs would be likely to limit their ability and willingness to step in and purchase more mortgages -- particularly in the most frozen of mortgage markets, including Alt-A and subprime. "Legislation needs to be enacted soon that would reform supervision of Fannie Mae and Freddie Mac," Lockhart said, "and, specifically, give a new agency authority to set capital requirements comparable to the authority the bank regulatory agencies possess." Lockhart suggested a more modern, Basel II-type approach to capital modeling was needed going forward. He also suggested that Fannie and Freddie could have taken a counter-cyclical role in the housing markets that might have prevented the massive housing and related asset bubble that has roiled financial markets in the months since it first popped. "[G]iven the Enterprises’ balance sheets, they might have refrained earlier than September 2007 from purchasing AAA-rated private-label MBS backed by subprime and Alt-A loans that did not meet the bank regulators’ guidances on subprime and nontraditional mortgages," he said. All of which begs the question: how much capital? It's a question analysts and Senate leaders alike have been bandying about as of late, with no clear answers emerging from the scrum. Most, however, seem to agree that more capital will certainly be needed if both Fannie and Freddie are to jump in and start greasing the wheels of the most frozen corners of the secondary mortgage market. The Senate is set to debate a housing relief package this week that would, among other proposals, push a long-stalled GSE reform proposal through Congress. The GSE reform bill would establish a new agency to regulate Fannie and Freddie, while giving the new agency much broader powers to regulate and establish risk-based capital requirements. While President Bush has said he will likely move to veto the package, due to a $300 billion proposed expansion of the Federal Housing Administration's mortgage insurance program, he has repeated expressed his support for the GSE reform bill. Disclosure: The author held no positions in FNM or FRE when this story was originally published. HW reporters and writers follow a strict disclosure policy, the first in the mortgage trade.