We publish this revised post from December 2nd for all of our readers. We corrected the earlier post, as noted, but the basic thesis of exit "as is" remains valid -- even more so now. Recap & release seems a given under the Administration of Donald Trump, but may be even more a challenge for mortgage markets than we first imagined.
December 11, 2024 | Premium Service | In this revised edition of The Institutional Risk Analyst from December 2nd, we return to the world of mortgage finance and talk about the process whereby Fannie Mae and Freddie Mac may finally emerge from conservatorship after 16 years of government control. A lot has changed in the secondary market for residential mortgages since September 7, 2008, when the United States seized the GSEs.
When the US seized the GSEs in 2009, they were insolvent on a mark-to-market basis, mostly on alt-A private mortgages that Fannie Mae and Freddie Mac purchased from other lenders. Reserves were taken and new capital was injected, all part of the 19th Century approach to finance that still informs action in Washington and is enshrined in government accounting. But if you are a GSE and have sovereign support, you don't need capital -- just enough cash to operate.
The Mortgage Bankers Association wants to see new legislation to facilitate early release of the GSEs, but our informal survey of DC housing mavens and Wall Street credit folk suggests that is not going to happen -- even with GOP control of Congress. We are reminded of the words of Professor Ed Kane from our 2021 discussion about COVID and monetary policy (“Ed Kane on Inflation & Disruption”):
“Many seem to be hoping that things will go back to the way things were, back to ‘normal.’ But I am always reminded of the concept of ‘hysteresis’ which basically says we may travel up one path in response to outside forces, but when these outside pressures subside, we should not expect that we will return to the same ways of doing things. We have to recognize that hysteresis is a general phenomenon. Investors, in particular, must ask what kind of paths will unfold if and when we establish herd immunity, and accept that the good old days cannot completely return.”
Bill Kilmer, Head of Legislative and Political Affairs of the MBA, reportedly said: “I think for this to happen this time, it’s really got to be led by the Treasury and by FHFA building a framework for the Congress to act upon. That may not be achievable in any one administration — unless you've got the right people that are going to dedicate the time and energy and effort to it.”
Ditto Bill, but we suspect that the new POTUS has a faster agenda in mind for the GSEs. President elect Trump brags of selling the US stake in the GSEs for a "huge gain." Huge. Watching tens of billions pouring into private credit, we think there is more than enough liquidity to absorb the government's stake in Fannie Mae and Freddie Mac. Below follows what will and also needs to happen if the Trump Administration really, really wants to release the GSEs without any new legislation. Can this be done? Yes, but be careful what you wish for. You may get it.
Our assumption based upon discussions with a number of people involved in the earlier process and past efforts is that President Trump will immediately announce his intention to release the GSEs from conservatorship. We suggest some significant business model changes for the GSEs. Some are problematic, like TBAs, and some may reduce the regulatory capital requirements of Fannie and Freddie. Subtle changes maybe even help the Treasury get par for its $200 billion equity investment.
At the outset, the GSEs will be majority owned by the United States once the Treasury exercises its preferred equity position. Using General Motors (GM), American International Group (AIG), and Citigroup (C) as models, Treasury is likely to seek an organized sale of some or all of voting stake in the enterprises upon release. But the Treasury does not need to sell all of its shares and could keep a modest stake (< 25%) to avoid the control. The big question is whether the Treasury can get par value for its stock for the GSEs “as is” or perhaps in a new iteration, as discussed below.
Source: Google Finance
You may call release “as is” the kamikaze route to GSE privatization. Pre-2008, we pretended that the GSEs were private and holders gathered supra-normal returns for taking no risk, as shown in the chart above. Owning GSE shares and preferred was like carried interest in private equity, a free ride on the US taxpayer.
Now we are going to behave like the GSEs are really private, but with a massive credit line from the Treasury and a specific resolution path created by Congress in the event of default. Fannie Mae and Freddie Mac, you understand, have never actually been “private” in terms of the credit markets, but don’t let that fact make you think that release is not a priority for the Trump Administration.
Upon release, the GSEs likely will get at least a credit rating downgrade from Moody’s et al. Today the GSEs are "AAA" rated buyers of loans who compete with the Federal Home Loan Banks in the primary market for residential mortgages. As private issuers, the GSEs face incremental future competition with customers such as JPMorgan (JPM), Mr. Cooper (COOP), PennyMac (PFSI), U.S. Bancorp (USB) and United Wholesale Mortgage (UWMC). The buy side hunger for larger private prime residential loans is insatiable.
Out of the gate, the US Treasury will own more than 80% of the GSEs on a fully diluted basis. The “sweep” used to to compensate the US for the investment in the GSEs is now ended and the government's stake is now accreting as if the Treasury received cash dividends. Contrary to our earlier note, there will be no amended sweep agreement with the US Treasury. And without legislation, there will be no direct government credit support for $8 trillion in residential and multifamily conventional MBS. Yeah.
Once the GSEs exit government control, however, the issuers will for the first time be treated as private companies and, more important, rated by Moody’s et al as finance companies instead of sovereigns. No amount of private capital replaces the full faith and credit of the United States. And only a sovereign credit earns a “AAA” rating from Moody’s. Federal support for the GSEs, keep in mind, is why we have a 30-year fixed rate conventional residential mortgage. Conventional MBS will be private credit, for now with a 20% risk weight for Basel III. Credit exposures to the GSEs will have 100% risk weight.
In the event of release w/o legislation, say sources who worked on privatization in Trump I, we should expect at least a one notch downgrade for the GSEs. The credit line from the Treasury under the preferred stock purchase agreement (PSPA) and the vast loan portfolios of Fannie and Freddie deserve a high investment grade rating, even more than the idiotic discussion of private capital behind a GSE.
As private issuers without the PSPA, however, the situation is less clear, especially if the Trump Administration chooses to put the GSEs through receivership prior to release. The GSEs should never have been placed into receivership in the first instance given the sovereign backing pre-2008. Yet the decision by Moody's and the other rating agencies going forward is the unknown variable in the process.
The credit downgrade of the GSEs could be more than one notch, depending on how Moody's views the degree of support from the United States and other factors. The example of AIG leaving government control in 2012, when the Treasury Department sold its last shares of AIG common stock, is the relevant example. The fact of government ownership allowed the Treasury to convince the ratings community that AIG should not be severely downgraded. The same situation applies here on day one. And recall, the conventional MBS has never been rated, depending instead on the issuer's "Aaa" Moody's rating.
Post-exit, however, the mortgage markets must decide whether conventional loans will continue to be eligible for too-be-announced treatment in the futures markets. "Established in the 1970s with the creation of pass-through securities at Ginnie Mae, the To-Be-Announced (TBA) market facilitates the forward trading of mortgage-backed securities (MBS) issued by the GSEs (Fannie Mae and Freddie Mac) and Ginnie Mae," notes SIFMA. "The TBA market creates parameters under which mortgage pools can be considered fungible and thus do not need to be explicitly known at the time a trade is initiated."
Now, there is no rating requirement in the TBA spec from SIFMA, but traders, risk managers, collateral custodians and loan administrators do make such distinctions. In the world of TBA, warehouse loans and gestation repos, there is very definitely going to be a growing distinction between government and agency collateral once the GSEs leave conservatorship.
In our original post, we supposed incorrectly that the GSEs could contract with the Treasury to buy credit enhancement for the MBS, but this is not possible according to sources close to the matter. Because the conventional MBS issued by Fannie and Freddie will no longer be treated as "AAA," a number of dealers we polled this week expect spreads to widen vs Ginnie Mae MBS. Whereas today MBS from the three agencies is essentially fungible as collateral on warehouse lines and in gestation facilities, in the future conventional MBS will be treated separately.
So for example, if the GSEs come out at "Aa2/AA" from Moody's and the other agencies, we may see a more formal bifurcation in the financing market including TBAs. Spreads, volatility and margin requirements may increase slightly, but a few basis points is enough for these markets to become distinct from zero risk weight Ginnie Mae collateral. Most traders and investors, for example, have no idea that the change in TBA status for conventional loans impends. Illustrating the Street's delusional view of GSE release, JPMorgan research wrote of the return of the implicit guarantee on 26 November:
"The quick summary: An explicit, paid for guarantee on the MBS is the only logically consistent course of action, for numerous reasons—but there’s no law preventing a return to a murky ‘implicit guarantee’ on nominally private Enterprises. It is extremely hard to raise enough equity in a short period of time to pay down Treasury’s senior preferreds, allow Treasury to exercise its warrants for 79.9% of the common, and to fully recapitalize the GSEs—but Treasury’s stake can be altered (and critically, CBO says that won’t require a Congressional “pay for”), as could the GSE capital plan. As for the motivation for taking action, the incoming President has stated that he would have privatized the GSEs and “sold the government’s common stock in these companies at a huge profit” if given the opportunity to replace the FHFA Director earlier in his first term. Taking the GSEs out of conservatorship also might allow the Administration to shape their footprint (think mission, investor/2nd, cross-subsidy, etc.)."
In the event of release "as is" for the GSEs, we think that the conventional mortgage market is likely to slowly shrink from the top down, leaving conventional issuers with smaller and more problematic loans in terms of probability of default, servicing cost and overall profitability. The bank/jumbo market, on the other hand, will grow as the now “private” GSEs compete with large banks and IMBs for bigger loans.
Just before the Thanksgiving turkey went into the oven, Jonathan Miller of Miller Samuel penned a provocative note in his must-read blog (“Fannie And Freddie’s Regulator Loves Moral Hazard Like I Love Cranberry Sauce”). He writes:
“It is clear from the chart that mortgage volume collapsed during the GFC but enjoyed a smaller spike during the pandemic. Note the spike in the conforming loan limit since the pandemic of 2020 – the spread widens substantially – but the gap has been widening for decades. The concept of lower loan limits, when prices fall, has never been entered into FHFA’s calculation. Certain markets a designated as high-cost, where the conforming loan limit exceeds 115% of the median sales price of the local county, the limit can be set up to 150%.”
Our question, inspired by the work of Laurie Goodman at Urban Institute and Ed Pinto at American Enterprise Institute, is why are we goosing consumer demand for housing in a supply constrained market? More financing means higher prices. But as we discuss below, if the GSEs come out of conservatorship, look for spreads on conventional loans and GSE unsecured exposures to rise in proportion to the credit downgrade. We also expect the market for jumbo and private bank loans to grow at the expense of volumes for the GSEs.
Five years after the release of Fannie Mae and Freddie Mac, the big banks, Ginnie Mae, the GSEs and private label loans could each have roughly a quarter of total mortgage market. Remember, JPM and other banks will pay up for larger, higher quality loans and servicing, and leave the smaller, less profitable loans for the IMBs and bond investors. And upon release, large banks and IMBs will have a significant operating efficiency advantage over the private GSEs.
Source: FHFA, Ginnie Mae, FDIC (Q2 2024)
Last week at the IMN MSR event, we asked whether truly private GSEs will be tempted or even compelled to retain the mortgage servicing rights from conventional loans. The GSEs do not currently retain the MSR at the point of purchase of the loan in the primary market and allow the sellers to retain and finance the servicing asset.
Given that the conforming limit for high-priced markets has just been raised another 5% for 2025 to $1.2 million, that servicing strip from larger, high quality conventional loans looks mighty tasty. The MBA says it costs $176 per year to service a performing conventional loan vs $1,800 a year for a delinquent loan. That 25bp conventional servicing strip on an average $350,000 loan is worth $875 a year. The 25bp servicing strip on a $3.5 million condo loan is worth $8,750 per year, but the cost of servicing is the same.
Bank owned mortgages are larger than average and have much lower delinquency rates. Now you know why large banks want nothing to do with smaller, lower-FICO loans and avoid government-insured loans entirely. You also now understand why JPM CEO Jamie Dimon is the biggest mortgage servicer and jumbo MBS issuer in the US. JPM cares only about bigger jumbo and conventional loans. And no, dear readers, Jane Fraser at Citigroup (C) has no desire to get back into government mortgage.
Yet at the end of the day, several mortgage operators tell The IRA that they think the GSEs will leave the conventional MSRs with the issuers, at least initially. The vast size of the GSE book of loans in conventional MBS provides a lot of cash flow to support profits and fund default servicing expenses when a recession and home price reset does eventually arrive.
GSE Release Checklist & Assumptions
The next director of the Federal Housing Finance Agency (FHFA) will need to ask a lot of questions as part of the process of preparing the GSE for release without new legislation. If we think of the checklist and assumptions from that perspective, and also the perspective of the US Treasury and Office of Management and Budget, below are the key questions and some assumptions in general order of priority.
The operational changes which must occur in a truly “private” Fannie and Freddie are substantial and include an entirely new management, finance and operating team at both enterprises. After more than a decade of QE and progressive insanity during the Biden Administration, the GSEs are entirely postal from an operational perspective. Large banks and IMBs, on the other hand, are bigger, hyper-efficient and not going to play nice in the secondary market for residential and multifamily loans. Today’s correspondents of the GSEs under conservatorship may become tomorrow’s competition for private GSEs.
While we don’t expect legislation to help the release of the GSEs, we hold out hope that the Trump Administration will use the Republican majority in Congress to separate Ginnie Mae from HUD as part of a larger government reorganization of mortgage finance.
In the brave new world of private GSEs, an independent and properly funded Ginnie Mae ought to eventually become the guarantor of all government insured MBS. But this also means that the GSEs could also resume purchase of private label mortgages, as they did prior to 2008, and other banks and IMBs could buy government insurance on MBS using the UMBS platform. And yes, both GSEs will remain joint and severally liable for all UMBS issuance even after release. Maybe we should just merge the GSEs into one? Annie Mae?
Legacy Business
When we think of the GSEs as stand alone issuers of MBS, they most resemble Ginnie Mae seller/servicers. The GSEs issue MBS and pay principal and interest directly to the securities holder via custodian banks. The GSEs own the loan and the servicing assets, which they allow the conventional “issuers” to encumber and trade. From a functional financial perspective, the GSEs must fund all of the related cash needs for purchasing and resolving delinquent loans. Given this operational reality, the key top-level questions are:
What is the broad business plan for the GSEs?
Which of their current business lines will continue post-release?
Which of their current business lines will be ended or curtailed?
What new activities will be added?
Will the GSEs continue to:
Buy first lien residential & multifamily loans,
Buy second liens and loans for second homes,
Issue MBS,
Guarantee the loans and MBS fully against default,
Reimburse conventional subservicers for all expenses, and
Allow subservicers to acquire conventional MSRs and control escrows?
In addition, will the GSEs be allowed to acquire other entities and assets? Could the GSEs, for example, acquire a depository to control conventional escrow deposits? Will the US government impose any ownership/control limitations on the voting shares of the GSEs? Will the US government retain any equity stake in the GSEs LT?
Issuer Rating
As part of developing the new enterprise business plan, FHFA and Treasury will engage with Moody’s and other rating agencies as they did during Trump I. The key issue: What unsecured credit rating for the private GSEs is targeted by FHFA and Treasury from Moody’s given the preliminary business plan?
A private issuer cannot achieve a “AAA” sovereign rating under the published criteria for Moody's and the other credit rating agencies. Also, post-release the GSEs are likely to come under pressure in terms of 1) profitability and 2) market share.
As a result, we expect a “Aa2/AA” senior unsecured rating from Moody’s for each GSE at release. If the GSEs experience market share loss and/or poor operating results subsequent to release, a further ratings downgrade will be possible. Market share and access to markets are the key factors in the Moody's ratings criteria for a finance company.
It is important for the Trump Administration to appreciate that leaving conservatorship implies a ratings downgrade for both GSEs simply for structural reasons. Large banks, for example, typically receive a notch of ratings uplift because of the assumption of sovereign support, but that enhancement does not make JPM a sovereign credit. Moody’s wrote in June 2024:
“While any deterioration in the company's asset quality and, in turn, capital levels would pressure the firm's standalone credit profile, the key determinant of whether Fannie Mae will retain its Aaa senior unsecured bond ratings will likely continue to be our assessment of (i) the extent to which creditors will benefit from the Government of United States of America credit support and (ii) the credit quality of the US government debt.”
As a result, we believe that the senior unsecured rating for the GSEs will be "Aa2" out of the gate and that, like a Ginnie Mae seller/servicer, the GSEs will continue to guarantee the underlying loans and police assets sold into any government-insured MBS for defects. If any loans in a conventional MBS go into default, the GSEs will need to fund the buyout of the loan at par.
Source: MBA, FDIC
Another important point in the analysis is that the Congress is likely to impose restrictions on the activities of the GSEs post-release. Once the FHFA and Treasury come to general agreement on the business model, it will likely look something like this:
Assume a one-notch downgrade from “AAA” from Moody’s to ~ “Aa2” for unsecured rating for the GSEs. MBS follows the issuer rating despite security.
Assume that the GSEs will privately guarantee all residential and multifamily loans and MBS without a Treasury credit wrap. This means a downgrade of $8 trillion in residential and multifamily MBS.
Assume that GSEs will retain ownership of all conventional loans and possibly the MSR strip in the future.
Bank and nonbank issuers will operate under the respective guides and will be reimbursed for expenses as today after four months.
Yes, that's right, we are going to downgrade $8 trillion in GSE MBS and hundreds of billions in corporate debt. Once the FHFA and Treasury agree on a general model for the GSEs post-release, then a new management team must be recruited for each enterprise. After more than a decade under government control, the GSEs lack the market and risk management skills to survive as private entities.
Once a business model is in place and a new management and operating team has been recruited, then the hard work of taking the GSEs out in the largest secondary offering in US history begins. From that point, we'd expect the process of rationalizing the operations of the GSEs, raising substantial new debt capital, and educating the industry about upcoming changes to take a minimum of 2-3 years. Think September 2027 as the target for release.
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