Earlier this month, the White House played the role of a NFL punter and punted the issue of what to do with Fannie Mae and Freddie Mac far downfield. In fact, maybe the next field over. Bond investors had eagerly awaited details regarding the future of Fannie Mae and Freddie Mac, which together, stand behind almost 40% of the outstanding bonds in the Investment-Grade U.S. Bond market, as measured by the Barclays Aggregate Bond Index. In September 2009 the Treasury stated that recommendations on potential solutions would be released with the President’s 2011 budget.
However, comments from the White House on a potential plan amounted to a single sentence stating the administration continues to “monitor the situation of the Government Sponsored Enterprises” (GSEs – the general term for all the federally chartered agencies) and “will continue to provide updates on considerations for longer-term reform of Fannie Mae and Freddie Mac as appropriate”. Edward DeMarco, acting director of the Federal Housing Finance Agency (FHFA – the regulator of the GSEs), followed with an “update” to Congress soon after but that merely consisted of an operational update with no discussion of future plans.
Investors Want More Clarity
Due to the complexity of the GSE issue, a detailed solution was not expected in early 2010, but investors were awaiting more clarity on one or two preferred solutions. In the absence of a detailed solution, little has changed in the potential solutions regarding Fannie Mae and Freddie Mac from those discussed in the marketplace several months ago that are outlined below:
- Nationalize Fannie Mae and Freddie Mac. This would essentially make GSE debt backed by the full faith and credit of the U.S. government. Since the GSE’s have $5.4 trillion in bonds outstanding (see Bond Types on the next page), between agency debt and Mortgage-Backed Securities (MBS), the government debt would increase by roughly 70%. Given the public outrage over the role Fannie Mae and Freddie Mac played in inflating the housing market and increased scrutiny over the budget deficit, nationalization is highly unlikely in our view.
- Privatize Fannie Mae and Freddie Mac. Unfortunately, Fannie Mae and Freddie Mac are still suffering losses and are too dependent on government assistance. Privatization does not look economically feasible at the moment. The Treasury has injected a combined total of $111 billion into the GSEs in the form of preferred stock with an onerous 10% dividend. In the meantime, delinquencies continue to rise for Fannie Mae and Freddie Mac while their overall pool of mortgages continues to shrink as mandated by regulators. With a rising number of mortgages still likely to default, and the cost of Treasury assistance fi xed, it is highly unlikely either of the two GSEs returns to profi tability in the coming two to three years. In fact, the Treasury may have to inject more capital into the GSEs as mortgage delinquencies are expected to peak around the middle of this year according to the Mortgage Bankers Association. Since defaults lag delinquencies, the GSEs may become even more dependent on the Treasury in the coming years. On December 24, 2009, the Treasury announced essentially unlimited backing of the GSEs through 2012 should the $200 billion backstop per institution be insufficient.
- Transform the GSEs into a regulated utility. 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 the creditworthiness of each mortgage applicant. Profi ts could also be capped under the utility structure. 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.
- Transform the GSEs into a good bank/bad bank structure. 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 while bad assets are put into a separate structure. However, this outcome would likely leave the bad assets on the Federal government’s balance sheet at a time of increasing scrutiny on the deficit. FHFA’s Edward DeMarco stated the only change that might be considered currently is to reconstitute the two companies under current charters. The comment is open to interpretation, and lacks details but we would view it as a possible move to a good/bad bank structure.
No Rush, No Surprise
We believe the White House is in no rush and a solution to Fannie Mae and Freddie Mac is likely a few years away. While the GSEs were criticized for their role in the housing market they remain the main game in town in providing affordable residential mortgages to homebuyers. According to the FHFA, Fannie Mae and Freddie Mac facilitated the origination of 78 percent of all residential mortgages issued in the U.S. through the fi rst three quarters of 2009. New bond issuance in the nonagency Mortgage-Backed Bond market — which are also bonds backed by residential mortgages but issued by large banks — only recently showed signs of life. It will be months, if not years, before the GSEs dominant role in facilitating the financing of residential mortgages diminishes.
More from GFC, Below
Progress on covered bonds, a potential replacement for Fannie Mae and Freddie Mac MBS, continues at a snail’s pace. Government discussions on creating a functioning covered bond market began during the financial crisis in late 2008 but there has been minimal follow up since. Federal Reserve Chairman Bernanke has endorsed the use of covered bonds as a solution and a smooth functioning covered bond market has operated in Europe for years. Covered bonds would also force banks to screen mortgage applicant credit worthiness more closely since the bonds are obligations of the bank and not simply handed off to a third party. Covered bonds may play a role in whatever solution is ultimately decided upon.
The lack of action from the Obama Administration means Fannie Mae and Freddie Mac will likely remain backed by the Treasury for several years
and investors can continue to use agency bonds and MBS as an option to Treasuries. For preferred investors, this implies that neither Fannie Mae nor Freddie Mac is likely to resume paying dividends on preferred securities over that time span. The Treasury backing is refl ected in the yields of GSE agency bonds and MBS. The average yield advantage, or spread, to Treasuries remains low by historical comparison [Charts 1 and 2]. To be sure, Fed buying of agency bonds and MBS has helped narrow yield spreads over the past 15-months. Although Fed purchases will end in March, as long as Fannie Mae and Freddie Mac remain supported by the Treasury, yield spreads are likely to remain on the narrow side of historical norms, a positive for bondholders. While we continue to prefer Corporate Bonds, investors who wish to maintain an allocation to government bonds may continue to use agency bonds and MBS as an option to Treasuries. For such investors, they can receive the administration’s punt and run with it.
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