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All aboard the GSEs

20 May 05:54 IFR SSA Special Report 2022 The US government-sponsored enterprises are in danger of becoming seen as a perpetual political merry-go-round. By Simon Boughey.

Fannie Mae and Freddie Mac, the US government-sponsored enterprises, or simply ‘the agencies’, constitute one of the oldest and most kicked political footballs in Washington. What Capitol Hill has in store for the agencies changes dramatically according to who holds the reins of power. In the last year, there has been a striking volte-face. While the Federal Housing Finance Authority director Mark Calabria was in situ, the GSEs were told to boost capital levels in preparation for an exit from conservatorship. But, in June 2021, Calabria was exited from the FHFA instead and an end to conservatorship has been kicked into the long grass. The GSEs are now expected to play a central role in the administration’s declared objective to extend affordable home ownership. This suggests there will be an extension of the credit box, as the GSEs accept borrowers with less established and less secure credit histories. As all MBS debt issued by the agencies is guaranteed by the full credit of the United States of America, this begins to look ominously a little like 2008. The danger to the American taxpayer that the GSEs represent has consequently come back into focus. However, there are differences this time around. First, the model that existed pre-crisis, by which happy shareholders took the gains when the GSEs made profits but the US taxpayer was there to bail the GSEs out if they did poorly, is a thing of the past. The agencies also claim there are now more tools at their disposal to mitigate risk, and the new leadership of the regulator clearly wants them to make greater use of these tools. Fannie and Freddie stress that the lesson of 2008 has been learned. ‘Even in a challenging economic environment, we remain committed to helping advance equitable and sustainable housing. Very importantly, I want to emphasise that we are taking on all of this work while maintaining our commitment to prudent and principled risk management,” said Freddie Mac CEO Michael DeVito when the agency’s first-quarter earnings were released. The back story Fannie Mae, or the Federal National Mortgage Association, as it was originally called, was a state-run organisation created in 1938 to restore the shattered US housing market. The business model was to buy up large quantities of housing loans from mortgage originators, take a fee for provision of a guarantee and then bundle the loans into mortgage-backed securities. The originators were thus freed up to take on more lending. In 1968, however, it became something rather different: an ostensibly private enterprise but one carrying an implicit government guarantee. From 1970, it was allowed to invest in private mortgages as well as federally insured loans and, in the same year, a sister organisation, now called Freddie Mac, was created. By early 2007, overall obligations of the agencies totalled US$4.5trn, only US$600bn less than the entire publicly held debt of the USA. Though the investor took on the interest rate and pre-payment risk, the agencies carried the credit risk. We know what happened next. The agencies suffered huge losses and reported a combined loss of US$8.7bn in the second half of 2007 alone. Congress had to step in, and the agencies received US$187bn of federal aid. In September 2008, the FHFA swept the two agencies into conservatorship, where they have remained ever since. Mark Calabria, a Trump appointee, was determined to get agencies out of conservatorship. He was not shy about this objective and declared it on several occasions. In a speech to the National Association of Homebuilders in Las Vegas in January 2020, he noted that even though the agencies had been recently allowed an increase of retained capital to a combined US$45bn, they guaranteed some US$5.5trn in single-family homes. “[Their combined leverage] still stands at around 300 to one. By contrast, the largest financial institutions in the nation have an average leverage ratio of roughly 10 to one. Given their risks and financial position, even in a modest downturn, Fannie and Freddie will fail,” he said. The consequences of failure were too painful to contemplate. “Many of the same warning signs that were ignored in the lead-up to the 2008 financial crisis have been reappearing,” he said. GSEs take centre stage But plans to return the agencies to private hands disappeared into dust when President Biden sacked Calabria. No one now expects Fannie and Freddie to be going anywhere. Taking GSEs out of conservatorship always looked a little far-fetched, depending, as it did, on the requisite amount of political appetite in Washington but also on the capacity of the agencies to build up enough capital to make them attractive enough to the private sector. “My consistent view, and I’ve had this since 2008, is that the GSEs will always exist. As much as during the Trump administration there was a huge focus on gearing them up for privatisation, we never saw that happen.” said Jeana Curro, head of agency MBS research at Bank of America in New York. Everyone in the market agrees that the GSEs are here to stay. Calabria’s successor, Sandra Thompson, also has a very different vision for them. Rather than dangerous encumbrances to be returned to the vicissitudes of the private sector as soon as possible, they are to be an integral element of the administration’s policy objectives. Having been marched to the top of the hill, they have now been marched down again. “Providing sustainable liquidity for affordable housing preservation, rural housing and manufactured housing in a safe and sound manner is an integral part of the enterprises’ responsibility to serve underserved markets,” said Thompson at the end of April, as the FHFA published its 2022–2024 Underserved Markets Plans. The provision of affordable housing seemingly involves a willingness to take on borrowers with less solid credit histories. “Will it require expansion of the underwriting box? It likely will require some incremental accommodation in guidelines, because broadening access to financing is a key to affordable housing, besides pricing,” said Mark Fontanilla, founder and CEO of Mark Fontanilla and Co., a specialist GSE mortgage data and index provider. How this will operate is unclear. In the past, as recently as 2018/2019, the GSEs relaxed the fees that they normally charge for borrowers with higher loans-to-value or higher debt-to-income ratios. No one knows what will happen until the agencies announce a new pricing structure. But, on the other hand, the GSEs have increased fees for second home mortgages, pushing potentially risky assets onto the private label market. At the same time, refinancing has contracted sharply from the boom period of 2020 and 2021. Mortgage rates have risen by 175bp this year, and there is now much diminished incentive to refinance. So, while one type of risk may be increasing, others have retreated. In fact, MBS issuance for 2022 is expected to be lower than was seen in the previous two years. Including bond sales from Ginnie Mae, US$3.157trn was priced in the TBA market in 2020 and US$3.475trn in 2021, but Bank of America expects this to drop to US$2.049trn this year. This is still higher than the US$1.5trn that was priced in the last pre-Covid year of 2019, but issuance will not surge to new highs due to novel, more affordable mortgages, it seems. Defensive linebackers There are also tools available to the GSEs to protect the taxpayer that were not there 13 years ago. First, there is a draw-down facility with the US Treasury to cover losses. This was last used in 2012. Second, the GSEs have developed a synthetic credit risk transfer market in the last eight years, by which they offer exposure to MBS market risk to investors in return for attractive spreads. Investors take the hit for the first 0.25% to 4% (the attachment points vary) of loss in newly acquired securitised mortgages, which compensates the agencies for reimbursements they would be obliged to make to investors in guaranteed MBS bonds. As an example of the spreads on offer, in the most recent Connecticut Avenue Securities (CAS) bond sold by Fannie Mae in the week beginning May 2, the Triple B rated M-1 tranche yields SOFR plus 190bp, while the weak Single B B-2 tranche yields SOFR plus 600bp. Mark Calabria thought the credit risk transfer market an expensive waste of time but the new FHFA welcomes its use. Capital rules which dated from the Calabria regime provided minimal capital relief for CRT but, under revisions introduced last year, capital relief provided by CRT mechanisms has been increased by around 30%. The effect has been immediate. Some US$14bn of CAS and Structured Agency Credit Risk (STACR) notes has been issued so far this year. This is equivalent to what is usually issued over the course of an entire year. It is estimated there will be US$25bn–$30bn of CRT supply in 2022, easily outpacing the previous record. This presents another bulwark between the GSEs and the US taxpayer. When the GSEs were swept into the arms of conservatorship during those tumultuous days in 2008, US Treasury Secretary Henry Paulson said the move was necessary due to the “inherent conflict and flawed business model of the GSE structure”. Fourteen years on, the GSEs are still standing. Reviled by one side of Capitol Hill, there does not seem to be much alternative. They are great survivors.


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