August 7, 2007

Joshua Rosner
646/652-6207
jrosner@graham-fisher.com




Please refer to important disclosures at the end of this report.
COMMENTS ON RECENT MARKET SPECULATION REGARDING THE GSEs

The lack of understanding and mass delusion about the ability of the GSEs to "save
us" may be best summed up in the comment from a portfolio manager that was included
in one of Mondays news stories; "Maybe the government regulators will allow them to
grow their portfolio now in a way they couldn't before, across the board, for jumbo,
subprime and conventional loans".

The GSEs cannot possibly, nor do I expect they would want to, be held responsible to
purchase the majority of unsalvageable problem loans that others originated. Recent
statements, including those by Richard Syron (see, as example
http://money.cnn.com/2007/08/04/news/companies/freddiemac.reut/?postversion=200708
0415) suggest that although the GSEs are interested in assisting many distressed
borrowers, the reality persists that there are a limited number of seriously distressed
borrowers who they would be able to assist. I view Mr. Syrons perspective on this issue
as prudent and responsible.

In fact, current regulatory guidance would likely prevent them from helping all but those
conforming limit borrowers who, given time or a basic change in mortgage terms, could
become current on their mortgages. I expect that to be the minority of impaired subprime
borrowers and not all of the impaired Alt-A borrowers.

A few points:

1) It would take an act of Congress to allow the GSEs to get into the Jumbo market. As
for a significant increase in their subprime exposures, the GSEs have historically avoided
outsized credit risk as a percentage of their businesses. Given ongoing internal control
issues, I would not expect them to aggressively take on such risks now;
2) The GSEs could step in, in a limited way, and securitize assets, they dont need larger
portfolios to do so;
3) The GSEs are bound by the non-traditional mortgage guidance so there is only so
much they could re-underwrite even if they wanted to save everyone. They themselves
are being required to adjust their automated underwriting systems to meet the
requirements of this guidance;
5) I suspect they may use their portfolios to hold modified assets they could have to buy
out of RMBS pools as a result of their guarantees;
6) I do not believe that OFHEO provided the information to the WSJ. It seems possible
that someone affiliated with FNM may have leaked the story to the WSJ, perhaps in an
effort pressure the regulator. Several large lenders/banks would also probably like to be
able to rely on the GSEs to purchase large volumes of originations. They too would have
an interest in leaking this or pressuring the regulator as well;

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7) Fannie's consent agreement with the regulator
( See: http://www.ofheo.gov/media/pdf/attachsettlement.pdf p.9 Article 3 Sec. 4 )
suggests that, barring specific internal events at FNM, it would require a significant
liquidity problem in the market for the regulator to have reason to lift the limits. Current
conditions do not seem to necessitate such an action. There is liquidity in the system for
decent credits albeit at higher rates. OFHEO, like the other regulators will likely continue
to monitor the situation for a further deterioration but I do not believe there is reason at
this point for them to view the market as illiquid;
8) The GSEs were among the early pioneers of low documentation loans, Automated
Underwriting, moves to lower allowable FICO scores. As early as 2004, 16% OF
FNMS portfolio had FICO scores below 660 (S&P 12/06). Similarly, even before the
recent speculative frenzy by buyers, FNMs 2004 exposures to second homes and vacation
properties was about 8% (S&P 12/06);
9) There is very little known about their loss mitigation practices and whether these
practices are effectively keeping borrowers in their homes or if they are merely pushing
losses off into the future. The increasing application of loss mitigation during the past
several years has almost certainly distorted the historic comparability of delinquency,
default and foreclosure statistics. As loans are mitigated the GSEs may be more likely to
hold those in portfolio thus creating further risks in a period of rising stress;
10) While the GSEs have been active in the refinancing market it is unclear how many of
those refinancing are from either subprime or FHA products where the borrower was able
to use home price appreciation in support of refinancing into a conforming product. 11) It
appears, prior to the recent requirement that they conform to the Joint Guidance on non-
traditional mortgages, one or both GSE were offering negative-amortization products that
seem not to have begun to fully amortize until after the reset period. (Higher-risk
products such as interest-only, sub-prime, Alt-A and negative amortization loans are
growing, but are currently about 20 percent of the book of business
http://www.ofheo.gov/media/pdf/OFHEOReporttoCongress07.pdf) As a result the GSEs
could use loss mitigation to assist borrowers but that might to come at some cost;
12) The GSE Risk Based Capital Rules require them to increase their haircuts against
counterparties as those counterparties ratings are downgraded. Currently 7 private
mortgage insurers insure about 17% of the GSEs book (roughly $400BB) and it is
unclear how the PMI industrys capital base (roughly $40BB) would have the ability to
absorb the possible (not necessarily likely) sizeable impact to their first loss exposures to
the GSEs book. These figures do not include other exposures of the PMI companies ( as
example: non-traditional mortgage insurance for second and high loan-to-value
mortgages). If the market continues to deteriorate there may also be risks to the abilities
of other counterparties to continue to act as economic counterparties;
13) We are in a period of increasing stress in the mortgage markets and will likely
continue to see rising mortgage industry levels of Alt-A and subprime REO. Regardless
of the direct impact to the GSEs book of business this would conceivably reduce the
recoveries on the GSEs REO portfolios;

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14) While investor expectations that the guarantee fees the agencies charge may rise
seem supportable, servicing expenses of the GSEs would also appear likely to rise;
15) While it is unclear if OFHEO will move forward on their plans or if any proposed
rules would be approved, OFHEO plans additional future rulemakings to address
substantial topics such as making adjustments to the loss severity equations used to
calculate Enterprise risk-based capital and the appropriateness of incorporating mark-to-
market accounting into the Risk-Based Capital Regulation. OFHEO also plans to update
the Minimum Capital Regulation to address fair value accounting and other issues; and
16) While the current shape of the Yield curve, the shift toward 30-year fixed product and
the anticipated resolution to their delinquent financial filings should help the GSEs, the
increased risk to credit quality, risk to counterparties, falling home prices, rising single
family inventories, rising REOs, increased servicing costs and potential increases in
required capital may cause unconsidered risks to the conforming conventional market and
the GSEs in turn.




















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