What does the latest Fannie/Freddie revamp mean?
On August 17th, the U.S. Treasury Department amended the terms of the conservatorship for the government-sponsored entities (GSEs) Fannie Mae and Freddie Mac. The changes are:
- Fannie Mae and Freddie Mac will no longer be required to pay the 10% dividend on the preferred stock (currently $189 billion) that the Treasury accumulates under the recapitalization plan set forward in the conservatorship arrangement. This change seems to acknowledge that, at $19 billion per year and growing, the dividend burden on the Treasury’s deferred stock had the potential to create more uncertainty and instability with regard to future dealings of Fannie Mae and Freddie Mac. The Treasury will continue to recapitalize the GSEs in line with previously determined limits in the event additional losses are incurred, but the removal of the heavy dividend burden helps ensure that those limits are not hit. In exchange, the Treasury is entitled to any profits that are generated by the GSEs. One of the side effects of this is that the GSEs will not be able to build any capital, since all profits will go to the Treasury. This largely ends any discussion of the GSEs being able to become standalone firms again.
- Starting in 2013, the GSEs will reduce their retained investment portfolios by 15% per year instead of the current 10% until they reach the cap of $250 billion. The retained portfolios will now reach that target in 2018 which is a full 4 years earlier than if they had kept at the 10% reduction per year.
While the Administration has made clear their desire to reduce the footprint of the GSEs with regard to their outsized proportion of mortgage lending, we believe these changes should be viewed as addressing longer-term safety and soundness as well as taxpayer fairness more than an acceleration in the wind-down of their overall business. The increase to 15% in the minimum annual portfolio reductions applies to their retained investment portfolios, not their credit guarantee business. Separately, we expect that there will be an additional announcement in the coming weeks that will highlight increases in the premiums charged by the GSEs for the credit guarantees. This would have the impact of both improving the long-term profitability of the GSEs as well as to allow private lenders to compete more with GSE mortgage lending rates.
What has been the market impact?
In the markets, the most noticeable reaction has been in agency debenture prices. With the retained investment portfolios shrinking even faster, the need for future debt issuance will fall, resulting in reduced supply going forward. At the same time, the relationship between the U.S. Treasury and the GSEs grows stronger, helping alleviate any credit concerns. As a result, agency debt spreads tightened versus Treasuries, with the impact most noticeable for longer maturity bonds. For their MBS securities, however, the reaction has been relatively muted thus far. Ginnie Mae MBS have weakened modestly relative to Fannie/Freddie MBS, leading some to believe that investors are placing less importance on the exclusive “full faith and credit” status of Ginnie Mae MBS. We would question this interpretation, however, and believe that recent weakness is more a function of the recent selloff and a supply overhang from recent Ginnie Mae issuance.
Will this change have any impact on MBS liquidity or volumes?
While this is a significant step toward full nationalization of the GSEs, until they become full faith and credit of the US government and/or risk weightings are aligned with Ginnie Mae, we do not see any significant impact on MBS pricing, liquidity, trading volumes or investor behavior. The acceleration of their retained investment portfolio liquidation could result in a moderate increase in selling in the coming years, but current prepayment rates alone will likely allow for natural runoff in their portfolios to account for most of the required reduction.