What's Good for Banks...

Fannie, Freddie
Should Have to Meet
New Capital Rules

By DAVID REILLY
July 9, 2008

Investors panicked earlier this week over the possibility that accounting-rule changes could force Fannie Mae and Freddie Mac to raise $75 billion in additional capital.

Even if the proposed changes make Fannie and Freddie take back onto their books trillions of dollars in securitized assets, it is up to regulators to decide how much capital needs to be set aside.

James Lockhart, regulator of the two mortgage giants, said as much Tuesday, noting that accounting rules don't dictate capital requirements. Plus, Fannie and Freddie already have set aside capital for these securitized assets.

Even if Fannie and Freddie dodge them, the new rules will hit banks. The rules, which govern the treatment of off-balance-sheet vehicles could potentially force Citigroup Inc., Bank of America Corp. and J.P. Morgan Chase & Co. to take billions of dollars in assets onto their books.

Banks don't currently set aside capital for those securitized assets. That means the new rules could force them to raise additional capital.

How much isn't clear, but the amounts involved are significant. Together, Citigroup, J.P. Morgan and Bank of America have securitized more than $1 trillion in assets, according to a report by RiskMetrics Group.

The proposed rules changes, which are likely to be finalized later this year, will eliminate special vehicles that allowed banks and others to keep securitized mortgage assets off their books, even though the institutions retained interests in them and serviced them.

The new rules also would require financial institutions to follow some common-sense principles in deciding if they control a vehicle, and so should consolidate it. These are whether a firm reaps the benefits from a vehicle or could be left holding the bag when things go wrong, and whether the firm can call the shots when problems emerge.

While banks' response to the proposed rules has so far been muted, they have a history of beating back challenges to their use of off-balance-sheet vehicles. When the Financial Accounting Standards Board tried to tighten the rules in the wake of Enron Corp.'s implosion, banks argued that the changes would deprive companies of low-cost, short-term funding.

That led to a loosening of the proposed rules, which allowed banks to engineer their way around them. Off-balance-sheet vehicles then helped fuel the securitization boom that inflated the housing bubble while leaving investors and regulators in the dark about the true risks facing banks.

This time around, fears about the impact on Fannie and Freddie could lead banks to argue that the changes will make the mortgage mess even worse and tie up capital that banks could use to shore up the economy.

FASB needs to stand firm in the face of such arguments. Banks need to set aside capital for the risks they face. The board also needs to reject calls for exceptions for Fannie and Freddie. That would only open the door for banks to argue for special treatment.

A failure to properly account for off-balance-sheet vehicles helped cause the financial crisis. Watering down prudent rule changes isn't going to relieve it.

VMware's Warning Chills Tech Sector

The revenue guidance issued by VMware Inc. Tuesday cratered the software company's stock, which plunged 24%.

VMware, the leading provider of software designed to help companies cut back on technology costs, said it expects 2008 revenue to be "modestly below the previous guidance of 50% growth over 2007."

That sort of growth rate might appear strong in this environment. But the warning implies a substantial slowing this year. In the first quarter, VMware -- split off by EMC Corp. last year in a popular initial public offering of stock -- posted revenue growth of nearly 70%, which means that pace has to slow markedly if it is going to come in under 50%.

Credit Suisse analyst Philip Winslow forecasts VMware's revenue growth will slow to 33% in the fourth quarter.

If corporate demand is falling that quickly for the kind of software that helps save money, earnings across the tech sector could disappoint.

The bulls will respond that with the Nasdaq down nearly 14% this year, tech stocks already reflect this. For example, Oracle Corp. trades at 14 times earnings for the fiscal year ending in May 2009, apparently cheap given that analysts expect earnings growth of 16% for the company in that period.

--Peter Eavis

Write to David Reilly at david.reilly@wsj.com