July 22, 2024 | Through the end of last week, the two leading stocks in the world of mortgage finance were unlisted penny stocks issued by Fannie Mae and Freddie Mac. In fact, the GSEs are up significantly over the past 18 months, not on the financial results for these parastatal entities but on the prospect for release from government control. Should investors take profits now or wait and hope?
Several readers have asked us to game out the process for taking the GSEs out of government conservatorship. Both of the GSEs are book insolvent and have seen volumes fall about 80% from the peak years of 2020-2021, so what’s to like? We wrote above the prospect for GSE reform for Kroll Bond Rating Agency back in 2017 ("Housing Reform 2017: Can the GSEs be Privatized?”).
First and foremost, both enterprises need to staff up with financial professionals with actual secondary mortgage market experience. After 14 years under government control, both GSEs need to rebuild their management teams and operational personnel to even begin to compete with private banks and mortgage firms. Neither GSE is prepared today to operate as a private issuer in a competitive secondary market.
But second and more important, if President Trump releases the GSEs from conservatorship, they are likely to fail again. Why? Because if we actually make the GSEs private companies for the first time in almost a century, they will lose their comparative advantage in the market for guaranteeing and selling residential loans. A private GSE with a "A+" rating from Moody's cannot sell insurance on residential mortgage loans for 55 bp per year -- especially if they have to compete with the large banks and nonbank issuers. Game over.
History buffs may recall that Freddie Mac was created in 1970 in order to compete with Fannie Mae. Now, however, post 2008 and since the passage of the Housing and Economic Recovery Act (HERA) and Dodd-Frank (2010), we can no longer pretend that the GSEs are sovereign credits.
Once the government begins the process of releasing the GSEs, both entities will likely be downgraded by Moody’s and the other rating agencies. And bank regulators likewise will increase the capital risk-weighting for GSE corporate debt as well. Why? Because the GSEs ultimately own the conventional mortgage loans and servicing assets, with all of the financial and operational risk this entails.
The GSEs combine an insurance function with the role of a mortgage bank, a business model that only works for a sovereign. When the enterprises purchase mortgages and issue guaranteed MBS, they retain the credit risk of those mortgages. They are exposed to potential losses if a borrower cannot pay back the mortgage. Moreover, the GSEs must reimburse conventional issuers for all expenses after four months and fund loss mitigation of delinquent loans.
Under the published ratings criteria used by Moody’s, only with unconditional credit support from a sovereign can a corporate issuer achieve a sovereign rating. Even with a federal charter and a credit line from the Treasury, the GSEs will still be considered to be “private” commercial entities for most purposes. Indeed today, the GSEs are largely treated as private entities in the world of mortgage finance and by the courts.
Notice in the graphic below that there is no government backstop behind the GSEs, which cover losses equal to at least 80% of the loan amount. If the private mortgage insurers renege of their insurance, and they usually do, then the GSEs eat the whole loss.
Source: GAO (2019)
Fannie Mae and Freddie Mac will indeed be private upon release and for the first time ever. Investors should ponder this point. Pre-2008, we all pretended that the GSEs were sovereign while private shareholders made double-digit returns. For this reason, before the GSEs can exit conservatorship, the Trump Administration will need to modify the agreement between the GSEs and the Treasury in order to allow for the continued sovereign backing for the existing and new mortgage backed securities (MBS).
Source: MBA, FDIC, FRED
Once the government announces its intention to release the GSEs, Moody’s et al will immediately prepare private corporate ratings for Fannie and Freddie using the finance company methodologies. The agencies may even place the GSEs on a watch for a downgrade before they are released and the shares are re-listed. While the credit markets and the enterprises themselves may be able to survive a one-level corporate downgrade to say “A+”, a downgrade for over $7.5 trillion in MBS would be a catastrophe for the housing market, banks and the US economy.
A sudden credit downgrade of trillions in conventional MBS would disrupt the residential housing market for years. Conventional MBS currently trade about 150 bp over Treasury debt. Imagine what happens to conventional MBS spreads in the event of a GSE ratings downgrade without a Treasury agreement to guarantee the MBS. Let's be generous and assume that private GSE MBS spreads widen to "only" +250 bp, suggesting hundreds of billions in losses to banks and other holders of MBS globally.
In August 2023, Fitch Ratings downgraded the credit ratings of Fannie Mae and Freddie Mac to AA+ from AAA, a day after it cut the US sovereign credit rating. In the event of a release from conservatorship, however, the ratings for the GSEs will drop below the sovereign rating for the first time since Fannie Mae was created in the late 1930s. Keep in mind that the ratings criteria for a private finance company are far more onerous than the criteria applied to a sovereign credit like Ginnie Mae, which is part of HUD. The table below shows the top-ten mortgage stocks sorted by 1-year total return.
Mortgage Equity Group
Source: Bloomberg (07/19/24)
The competitive analysis performed by Moody’s, for example, will place the private GSEs in a secondary market for residential mortgages already dominated by JPMorgan (JPM), which has a “Aa2” Moody's rating for the bank and will have a far lower cost of funds than the GSEs post release. Again, figure that "private" GSE debt will trade wide of the yields on agency corporate debt.
Notice that the risk-implied credit default swap (CDS) spread estimated by Bloomberg is currently 16 bp for the GSEs, 40 bp for JPM, 100 bp for Mr. Cooper (COOP) and ~ 20bp for the Federal Home Loan Banks. Post-release, we could easily see the spread for the private GSEs widen to 50 bp or more. Our best guess is that upon release, the corporate debt of the GSEs will trade at 1.5x the spread for the FHLBs in the credit markets.
One big negative factor that the rating agencies must consider is that the GSEs will be forced to pay a large chunk of their insurance revenue to the Treasury to cover the existing and new MBS. The private GSEs must compensate taxpayers for renting the “AA+” credit of the United States. If we assume that the GSEs will pay the Treasury ~ 15-20 bp per year on over $7.5 trillion in conventional MBS, then that represents about 40% of the pre-tax insurance earnings of the GSEs. The average guarantee fee (gfee) charged by Fannie Mae in Q1 2024 was 54 bp.
But what happens when the GSEs are forced to reduce their gfees because of competition for loans from JPM and the large nonbank issuers? Remember, the conventional MBS will be guaranteed by the government, but the GSEs will be private finance companies, albeit with high investment grade ratings. Their funding costs may be twice that of JPM and other banks, such as U.S. Bancorp (USB), the second largest bank originator of 1-4 family loans after JPM. The FHLBs are paying over 5% for short-term funding today vs half that amount for large banks.
The nonbank mortgage issuers led by Rocket (RKT), United Wholesale Mortgage (UWMC) and PennyMac Financial (PFSI) are orders of magnitude more efficient than the GSEs when it comes to buying loans. Smaller bank issuers, like Western Alliance (WAL) and their AmeriHome Mortgage unit will also be bidding aggressively for loans in a volume constrained market. Given the cutthroat competition for conventional loans, just how do advocates of release expect the GSEs to survive?
Residents of Washington who believe that private mortgage issuers will not go after the market share of the GSEs in correspondent lending on day one are ignoring basic market realities. Private GSEs could easily lose most of their correspondent business post-release. Given that most of the major nonbank issuers are losing money on every conventional loan they make today, led by Matt Ishbia at UWMC, how do private GSEs survive?
In addition to losing much of their conventional loan business, private GSEs will be forced out of the mortgage guarantee business. If JPM, PFSI and/or UWMC want to pay the government to wrap conventional MBS in a “AA+” sovereign rating, why should the Treasury say no? The end of the GSE's role as a public mortgage guarantors is, in fact, the big, unspoken issue in the GSE release narrative.
If the GSEs are privatized and have an arrangement with the US Treasury to guarantee private MBS, why can’t JPM or any other private issuer get the same deal? The answer is that Treasury will be forced to offer the same deal to all issuers. And again, the GSEs are so operationally inefficient compared to JPM or PFSI or any of the top 25 nonbanks issuers that even suggesting competition is absurd.
Now most of the people in Washington who think they understand housing generally do not understand any of the issues discussed above. The Washington mindset on the GSEs is still a function of the pre-2008 world. In those happy days, private investors could benefit from supra-normal returns in GSE common stock and preferred equity that were government guaranteed. But the operating leverage in the GSE model comes from government support. The private equity capital inside the GSEs is largely irrelevant to the credit standing.
That last fact, the role of private capital, is a major problem in Washington. A number of prominent conservatives led by former Federal Housing Finance Agency head Mark Calabria, are fascinated by the idea of privatization and ending bailouts for large banks and companies. Trouble is, when a financial institution gets to a certain size and scope, it can only function with sovereign support. All US banks, for example, benefit from sovereign support via FDIC insurance, which is good for a full notch of uplift on bank ratings.
Once sovereign support ends, however, so too does the opportunity to earn supra-normal returns for private GSE capital. Once the government converts its preferred equity into common, dramatically diluting the existing holders, we suspect that the shares will reflect the actual financials of the respective issuers. If as we suspect the GSEs are forced to pay away a significant chunk of their insurance revenue to the Treasury re-insure the conventional MBS, what’s left over is not going to be much of a business. The Treasury may not even get par for their GSE shares.
Today the lofty share prices for Fannie Mae and Freddie Mac are a function of the pump-and-dump game played by certain Wall Street firms over more than a decade. Fannie Mae peaked back in March at $1.80 per share and has since lost almost 40 cents or a quarter of its value. Our view is that the long-suffering shareholders in the GSEs ought to take advantage of these periodic episodes of speculative exuberance in the orphaned securities issued by Fannie Mae and Freddie Mac before 2008.
We think that the odds of the GSEs ever being released are very long indeed and that shareholders should take short-term trading profits rather than playing the long game that certain unscrupulous dealers are promoting. Political appointees can speculate about GSE privatization, but ultimately the professional staff at the Treasury and OMB will make the call.
That said, if a future Trump Administration disregards the advice of the Treasury and is foolish enough to release the GSEs as they are today, then we think both enterprises will stand a very good chance of returning back to conservatorship within a year. But at the end of the day, that is precisely the outcome that large banks and conservatives in Congress have always wanted; to destroy the GSEs and leave the mortgage market in private hands other than government lenders and Ginnie Mae. Josh Rosner was right.
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