A market bombshell released yesterday by Standard & Poor’s left many industry participants unsure of just what to think next, as the rating agency surprisingly suggested that the credit risks now being taken on by both Fannie Mae (FNM) and Freddie Mac (FRE) — as well as the Federal Home Loan Banking system — may be sufficient enough to threaten the U.S. government’s ‘AAA’ sovereign credit rating. “We believe [the GSEs] pose large contingent fiscal risks that recent policy decisions aimed at supporting the U.S. mortgage market have made even larger,” wrote S&P’s John Chambers and Nikola Swann, who co-authored the report released on Monday. “If these risks were to translate into increased government debt, they could even hurt the U.S.’s credit standing.” The GSEs are certainly being asked to take on more risk. The U.S. Treasury and the Office of Federal Housing Enterprise Oversight relaxed the GSEs’ capital surplus position in March to 20 percent from 30 percent, while also loosening previous restrictions on portfolio growth. Both Fannie and Freddie are also now authorized — albeit temporarily — to purchase so-called “jumbo conforming” mortgages with a lending limit up to $729,750, as part of the Economic Stimulus Act of 2008. While S&P characterized any potential credit damage to the U.S. itself as “unlikely,” the rating agency said that the fiscal risks of supporting the GSEs far outweighed any risks associated with propping up the broker-dealer segment of the U.S. financial system — a la Bear Stearns. In a deep and prolonged recession, S&P estimated that the maximum potential cost of assisting the broker-dealer sector remains small compared with the size of the economy, at just below 3 percent of GDP. However, an equivalent measure for GSEs, together with loans and guarantees extended by explicitly-guaranteed U.S. government agencies, yielded a potential fiscal cost to the government of up to 10 percent of GDP, S&P said. “Standard & Poor’s does not predict a deep recession,” said John Chambers, chairman of Standard & Poor’s sovereign rating committee. “Even under a severe stress scenario, the contingent fiscal risks of broker dealers will not threaten the ‘AAA’ rating on the U.S. government. However, under such a scenario, the size of GSEs, coupled with their current level of common equity, could create a material fiscal burden to the government that would lead to downward pressure on its rating.” It’s a finding that would seem, on its face, to fly against the theory that says Bear Stearns needed to be bailed out in order to prevent an unraveling of the U.S. and global financial system. “We expect the mortgage GSEs to raise substantial amounts of equity to meet their capital adequacy needs,” said S&P credit analyst Victoria Wagner. “We will be looking closely at their forthcoming plans to shore up their common equity base as they attempt to preserve the ‘AA-‘ rating and limit the risk they present to the ‘AAA’ rating on the U.S. government.” For more information, visit http://www.standardandpoors.com.

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