Saturday, December 26, 2009

Treasury Moves Raise Questions about Expanded Role for Fannie Mae and Freddie Mac

A Treasury announcement Christmas Eve raises a lot of questions about the future of Fannie Mae and Freddie Mac.
  • Is the Administration planning a future where the two companies become permanent government agencies?
  • Is the Administration laying the groundwork to expand the capacity of the two agencies to retain more mortgages and buy more mortgage-backed securities?
  • Is the Administration planning to ramp up loan modifications involving principal reductions, which would mean more near-term losses for Fan and Fred?

Those are some of the questions posed by mortgage industry consultant Ed Pinto.

By Robert Stowe England
MindOverMarket.blogspot.com

December 26, 2009

Treasury released a statement on changes affecting the role of Fannie Mae and Freddie Mac on Christmas Eve, a time when they might be expected to escape more intense press scrutiny.

"The timing of this executive order giving Fannie and Freddie a blank check is no coincidence," Rep. Spencer Bachus (R-Ala.), ranking minority member on the House Financial Services Committee, told the Wall Street Journal. It was done "to prevent the general public from taking note."

The policy changes deserve close public scrutiny.

First, and foremost, the cap on the amount of money Treasury will invest in preferred stock has been removed. It was set at $200 billion each for Fannie and Freddie in September 2008 under the Preferred Stock Purchase Agreements (PSPAs) that were adopted to ensure that each agency maintained a positive net worth.

As the Treasury stated it in its press release:

Treasury is now amending the PSPAs to allow the cap on Treasury's funding commitment under these agreements to increase as necessary to accommodate any cumulative reduction in net worth over the next three years. At the conclusion of the three year period, the remaining commitment will then be fully available to be drawn per the terms of the agreements.

So far, Treasury had provided $51 billion to Freddie Mac and $60 billion to Fannie Mae through the third quarter of 2009.

As Treasury stated it:

The amendments to these agreements announced today should leave no uncertainty about the Treasury's commitment to support these firms as they continue to play a vital role in the housing market during this current crisis.

Secondly, Treasury is amending the prior agreement concerning the level of mortgage-backed securities that can be retained by Fannie and Freddie. In September 2008, a cap of $850 billion was set for the end of 2009.

Treasury has now raised the cap to $900 billion for 2010 and beyond.

Further, the original agreement called for a gradual reduction on Fannie's and Freddie's holdings of mortgages and mortgage-backed securities, which have been the chief source of huge losses for the two mortgage agencies.

The ultimate goal was to reduce each company's retained mortgage and mortgage-backed securities portfolio by 10 percent a year until it reaches $250 billion. It was capped at $850 billion. The scheduled reductions will now begin from a peak of $900 billion in 2010.

Here's the text on the changes to the caps:

Treasury is also amending the PSPAs to provide Fannie Mae and Freddie Mac with some additional flexibility to meet the requirement to reduce their portfolios. The portfolio reduction requirement for 2010 and after will be applied to the maximum allowable size of the portfolios – or $900 billion per institution – rather than the actual size of the portfolio at the end of 2009.

While this policy appears to be a bit cryptic, Treasury explains it as follows:

Treasury remains committed to the principle of reducing the retained portfolios. To meet this goal, Treasury does not expect Fannie Mae and Freddie Mac to be active buyers to increase the size of their retained mortgage portfolios, but neither is it expected that active selling will be necessary to meet the required targets. [The Federal Housing Finance Agency] will continue to monitor and oversee the retained portfolio activities in a manner consistent with the FHFA's responsibility as conservator and the requirements of the PSPAs.
It appears that the two government-sponsored enterprises (GSEs) will not actually be required to sell securities to reduce their overall holdings. Nor does it appears they wil be retaining more mortgages or buying mortgage-backed securities.

Instead, the policy suggests that the potential decline could occur through attrition of the portfolio holdings (due to a range of activities from refinancings to loan payoffs when houses are sold).

Thirdly, Treasury announced that the program established in September 2008 to allow for the purchase of Fannie and Freddie-guaranteed mortgage-backed securities will end December 31. Treasury expects to have purchased approximately $220 billion of securities across a range of securities through this program.

Preliminary Plan

Treasury also indicated in its statement that the Administration is "reviewing issues around longer term reform of the federal government's role in the housing market," and will provide a preliminary report on its vision for the future of Fannie and Freddie in February when a budget is released for 2011.

The Treasury statement tried to reassure taxpayers and investors that the Administraiton remains intent on sound mortgage underwriting standards for not only Fannie Mae and Freddie Mac, but also for the Federal Housing Authority.

Treasury also indicated in its statement that it anticipated a return to a larger role for the private sector, without defining what that role might be beyond having the private sector expand its purchases of mortgage-backed securities at the same the government and Federal Reserve reduce their purchases.

The Federal Reserve has kept the mortgage-backed market strong and interest rates low for more than a year due to its commitment to purchase $1.2 trillion in mortgage-backed securities issued by Fannie and Freddie.

The Fed purchase program is supposed to end in March, raising concerns about higher interest rates crimping the potential for a recovery in the housing sector.

The entire text of the Treasury announcement can be found at this link: http://www.treasury.gov/press/releases/2009122415345924543.htm

Compensation

Christmas Eve was also the timing for announcements from Fannie and Freddie on the compensation packages for senior executives.

Fannie Chief Executive Officer Michael Williams and Freddie CEO Chalres Haldeman Jr. will receive about $6 million each, including bonuses. FHFA and Treasury approved the pay packages.

The compensation packages are down by 40 percent from prior to conservatorship, according to FHFA.

The packages also do not include any stock options for the two companies, whose shares have remained severely depressed. Fannie Mae (ticker symbol FNM) closed at $1.05 December 24, while Freddie Mac (ticker symbol FRE) closed at $1.26.

The Treasury and GSE pay package announcements were made after the stock markets closed early at 1 p.m. December 24.

Questions Raised

Mortgage market guru Edward Pinto, who was chief credit officer at Fannie Mae from 1987 to 1989, has issued a statement indicating the types of questions he thinks are raised by the Christmas Eve announcements.

For one thing, the announcements may suggest that Treasury and FHFA are expect rising losses (and bailout costs for Fannie and Freddie) from the Homeowner Affordable Housing Program or HAMP loan modification program, Pinto says.

Pinto asks if the HAMP program might be refocused to incorporate principal reductions, with sharper short-term losses, and not just lower interest rates, which spread losses out over time.

The announcements also raise the possibility that the Obama Administration plans to keep Fannie and Freddie as government-owned companies and does not intend to try to return them to the private sector, according to Pinto. The failure to pay the top executives in stock options raises this issue, he explains in a statement, which is printed at the end of this story.

Raising the portfolio limits to $900 billion (from $850 billion) allows Fannie and Freddie combined to purchase up to $275 billion in mortgage-backed securities, enough to continue that program for four or five months at the same pace that has been maintained by the Federal Reserve over the course of the last year.

Also, by raising the level of the federal government's financial (and bailout) commitment to Fannie and Freddie, Treasury may be setting the stage for Fannie and Freddie to expand their role in purchasing mortgage-backed securities, Pinto says.

These efforts may be intended to keep interest rates from rising so high that it puts a damper on the recovery underway in the housing sector.

Further, changes in the way banks are required to set aside capital reserves for holdings of mortgage-backed securities (not included in the Treasury announcement) could increase demand for those securities, according to Pinto.

Pinto's statement appears below.

Copyright © 2009 by Robert Stowe England. All Rights Reserved.




STATEMENT BY ED PINTO, DECEMBER 26, 2009:

What the Treasury’s lifting of the bailout caps on Fannie and Freddie might portend for 2010

Might Treasury be taking these steps in anticipation of the following?

1. Revisions to the flagging Homeowner Affordable Housing Program (HAMP). Any changes will likely increase near term bailout costs to Fannie and Freddie if HAMP’s current reliance on interest reduction is replaced in part by principal reduction. The losses associated with a modification of a loan using an interest rate reduction are spread out over time while a modification using principal reduction results in taking a more immediate loss.

2. Fannie and Freddie taking on a greater role in the near term to support their own mortgage backed securities (MBS). Now that the Treasury’s and the Federal Reserve’s own support programs are in the process of winding down, the administration’s actions may be preparing Fannie and Freddie as the vehicles for continuing this support. The Treasury’s December 24, 2009 announcement raises the portfolio limits to $900 billion each, thereby providing Fannie and Freddie with the ability on a combined basis to increase their portfolios by a total of $275 billion. At the current rate of the Fed’s MBS purchases, this new capacity would last about 4-5 months.

3. Fannie and Freddie growing their portfolios on a long term basis to provide continued support to the MBS market. Given the recent uptick in mortgage rates due to increasing Treasury rates, the lifting of the bailout caps may be designed to reassure investors in an effort to keep MBS spreads from widening relative to Treasury rates. By providing a more open ended capital commitment, along with the greater portfolio capacity now, Fannie and Freddie are in a position to grow their portfolios early in 2010. If the market accepts their purchases without wider spreads, then even higher portfolio dollar limits can be created with the stroke of a pen;

4. The administration’s announcement in February regarding the future role of Fannie and Freddie. In a separate press release also issued on December 24, 2009 it was revealed that the executive pay packages at Fannie and Freddie do not include a common stock component. This fact, along with the lifting of the bailout caps and the expanded portfolio capacity, may well indicate an intention to formalize Fannie and Freddie’s continued status as government agencies. If this were to happen, Fannie and Freddie’s outstanding common stock likely becomes worthless, making it of no use as an employee incentive. This action would be justified by stating that Fannie and Freddie are just too important to the economic recovery to re-privatize.

5. Increasing the demand for Fannie and Freddie’s MBS by reducing the multiplier for bank risk based capital requirements from 20% to 10%. This action would help serve to keep spreads to treasuries narrow. Banks would only need 0.8% risk based capital to support their holdings of Fannie Freddie MBS versus the 1.6% needed today. The earlier noted lifting of Treasury’s capital support caps could provide the justification for this reduction in capital requirements, since it signals an increase in the government’s commitment to Fannie and Freddie.

The above actions would preserve and strengthen the government’s involvement and control over the country’s housing finance system and make it harder to reintroduce substantial private sector involvement later on. They would also continue distortions in the marketplace leading to who knows what unintended consequences. Finally these steps would do nothing to deleverage the housing finance system, a key step in returning it to any degree of normality.

Edward Pinto
Consultant to the housing finance industry and former
chief credit officer
at Fannie Mae from 1987-1989.
Voice: 240-423-2848
Fax: 301-229-2848


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