January 16, 2025 | Premium Service | In this issue of The Institution Risk Analyst, we look at the good and the bad in Q4 2024 bank earnings from two of the largest US banks. But first we wanted to share an observation about the prospect of releasing the GSEs, Fannie Mae and Freddie Mac, from conservatorship.
Earlier this week, Mark Zandi of Moody’s Analytics and Jim Parrott of Urban Institute, nicely laid out the case against releasing the GSEs without new legislation (“Fannie and Freddie’s Implicit Guarantee: Another Iceberg on the Path to Privatization”). The key paragraph in the piece is below:
“In its recent note on how it would rate the GSEs if released from conservatorship, Fitch discusses the impact of the level of government support assumed. It states that it would likely continue to align the GSEs’ rating with that of the government, but partly because Fitch assumes the GSEs would retain a 'dominant market presence.' We take this to mean that Fitch is assuming that the government would remain committed to bailing out the GSEs if they failed—that they have an implicit guarantee. We believe that other ratings agencies would also continue to align the ratings of the GSEs with that of the government if they assumed an implicit guarantee. But we believe that they would downgrade the GSEs meaningfully if convinced that they were being released without the implicit guarantee.”
In simple terms, if and when the GSEs exit conservatorship w/o legislation from Congress, the conventional secondary loan market is basically kaput. Loans guaranteed by Fannie Mae and Freddie Mac will no longer be “risk free” assets, which means that the options for financing conventional loans will dwindle.
For example, conventional loans will no longer be “eligible for pooling” for the purposes of term REPO and bank warehouse lines. Conventional loans will no longer be eligible for the to-be-announced (TBA) market and they will effectively become private label loans. Hedging interest rate risk related to conventional loans will become more costly and, in many cases, problematic outside of bank warehouse financing. Sound like a disaster? Yup.
The conventional market will divided into a bank market for larger, above average (~$400k) loans and below-average loans, which will migrate back to FHA/VA/USDA and Ginnie Mae. In a release "as is" scenario, it is easy to see secondary market spreads rising at least 1% in the event, meaning that the cost to consumers for a conventional loan will rise by at least that amount.
A senior member of the ratings community summed things up after reading the Zandi/Parrott analysis: “I thought they would have come out even stronger re: MBS. MBS have to be viewed as risk free otherwise exit from conservatorship does not work in all markets, not just stressed markets.”
The same well-placed observer notes that an equity raise for the Treasury upon release is a really bad idea and, in fact, will be really hard to achieve w/o weakening the credit standing of the GSEs. As we’ve noted and he adds, we don’t know what the profitability of Fannie and Freddie will be as we do not know where MBS and unsecured debt will trade post-release.
We continue to believe that the odds of actual release from conservatorship for the GSEs remains 1:5 or less. The reason is very simple. Most investors in conventional MBS cannot conceive of a world in which the bonds are not risk free assets. It does not compute. Once a large enough crowd of people comes to appreciate the realities of releasing the GSEs "as is," the proposal will become politically toxic and the various trades and financial institutions will oppose it.
If we actually convince a large number of global bond investors that President Donald Trump is reckless enough to crater the $7 trillion conventional loan market to he can force another tax cut through Congress in 2025, then the selloff in MBS and also Fannie and Freddie unsecured exposures will be massive. The collapse of the conventional loan market may even lead to a larger selloff in the US markets. There, we said it.
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