Les Cyclettes des Rome

Continuing a theme from last week’s Bond Market Perspectives, this week we take a closer look at Fannie Mae and Freddie Mac, the two largest Government Sponsored Enterprises (GSEs), one year after being placed into conservatorship under the Treasury. Both Fannie Mae and Freddie Mac were at the heart of the credit crisis, and their bonds, including Agency Debt and Mortgage-Backed Securities (MBS), comprise roughly 40% of the bonds in the broad Barclays Capital U.S. Aggregate Bond Index. Despite their significant presence in the bond market, there is little if any clarity on the future of Fannie Mae and Freddie Mac. A year ago, the options seemed relatively straightforward: maintain them as nationalized entities, make a clean break with the government to launch them as private companies, or provide interim support and return them to their pre-crisis GSE form.

Limited discussions over the summer suggest any reform of the GSEs is a long way off. First and foremost, the Obama administration has delayed looking into the future of Fannie Mae and Freddie Mac until early next year. Over the near term, healthcare reform is a top priority for the President and lawmakers. If and when healthcare is resolved, the administration appears more intent to focus on other legislation such as expanded regulation of financial firms, reformed regulation of financial markets, and expanded consumer and investor protection laws. Each, let alone all, is an onerous task, and we would not be surprised to see GSE reform punted further into 2010.

Solutions for Fannie Mae and Freddie Mac

Aside from delay, potential solutions for Fannie Mae and Freddie Mac have grown more complex compared to the initial three-scenario outcome outlined above. Additionally, a good bank/bad bank structure under the government and a utility structure have been discussed. Similar to what was discussed for the large banks, a good bank/bad bank structure would potentially split Fannie Mae and Freddie Mac into two separate entities but leave the “good” part to continue in its current capacity. A utility structure could take any one of several forms. A cooperative structure wherein the GSEs share credit risks with mortgage underwriters would give underwriters greater incentives to monitor applicant creditworthiness. Another form could involve the GSEs as partial guarantors, or guarantors of last resort, subjecting investors to a limited amount of credit risk before government support stepped in.

Market implications have also complicated the path of potential solutions. Residential mortgages are bundled and then sold to investors as bonds, and disruptions to the bond market must be minimized. Any solution must limit disruption to bond markets, particularly with Fed purchases currently set to expire at the end of this year. According to Fed data, the GSEs accounted for 73% of all mortgage originizations in 1Q09. Their importance to the mortgage market cannot be underestimated, and solutions must involve both the ownership side as well as potential market impact.

Due to the highly politicized nature of discussions, the future form of the GSEs is unknown. To reduce inefficiencies the government would like to curtail support but the market is not ready to support a fully private entity. We believe that a cooperative type structure is most probable and potentially best solution for all parties involved.

Look to the Future

The future of Fannie Mae and Freddie Mac will very likely require some sort of legislative assistance. Fannie Mae’s best year from a net income perspective was 2003, when it produced net income of $8 billion. Since Fannie Mae pays 10% on capital owed to the Treasury, which currently totals $45.9 billion, annual payments ($4.59 billion) to the Treasury present a high hurdle for Fannie Mae to clear to be successful as a private company even in good times. Although its Q2 net loss of $14.8 billion was a notable improvement from its net loss of $23.2 billion in Q1, Fannie Mae has a long way to go before becoming profitable again soon. Freddie Mac faces a similar situation.

Despite the future uncertainty and poor financial results, GSE debt has benefited from Fed purchases and Treasury backing as evidenced by narrower yield spreads. To be sure, cheap valuations first attracted investors to GSE debt last December, and Fed buying provided a powerful tailwind. Narrower yield spreads enabled both agency and MBS bonds to outperform Treasuries in 2009.

Looking forward, the uncertainty over the future of Fannie Mae and Freddie Mac suggests both GSEs will remain under the umbrella of the Treasury for longer than initially anticipated. This view also suggests that neither will resume paying dividends on preferred securities anytime soon. However, the credit support provided by the Treasury is a positive for bond holders. The end of Fed purchases at the end of this year could lead to weakness in both agency bonds and MBS. However, agency bonds and MBS do not face the supply deluge occurring in the Treasury market. We would view any weakness as modest as top credit quality and more favorable supply/demand dynamics will likely keep yield spreads near historically tight levels. As long as the Treasury is backing Fannie Mae and Freddie Mac, their agency bonds and MBS remain a viable alternative for investors seeking top credit quality bonds.
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