August 17, 2022 | One of the more amusing tasks we have at The Institutional Risk Analyst is explaining to readers, old and new, why the government sponsored entities (GSEs), Fannie Mae and Freddie Mac, will likely sit in conservatorship indefinitely unless and until Congress acts first. It has been almost 15 years since the Treasury retook explicit control over the GSEs, yet the $7 trillion in conventional MBS guaranteed by these two “private” issuers is still not included in the national debt of the United States.
There are well-intentioned people in Washington who continue to believe that, given the right political alignment, the GSEs will be recapitalized and released from conservatorship and the U.S. Treasury will recoup its full investment. Yet getting from here to there is a lot more complicated than most Washingtonians appreciate, one reason why former Treasury Secretary Stephen Mnuchin ultimately did nothing at the end of the Administration of Donald Trump.
The first thing to understand about the GSEs is that, post 2008, post-Dodd-Frank and multiple amendments to the Basel capital guidelines, we can no longer pretend that these federally chartered corporations are sovereign credits once they leave government control. Under conservatorship, Fannie Mae and Freddie Mac are “AAA/AA+” credits, referring to the sovereign rating for the United States from Moody’s & S&P, but once they leave conservatorship, the rating drops.
Under Basel capital rules, Ginnie Mae obligations have a zero percent risk weight for banks and the obligations of the GSEs have a 20% risk weight or $2 per $100 of risk exposure. In the world of Basel capital rules, 100% risk weight equals $8 of capital per $100 of exposure. As the GSEs exit conservatorship, the risk weight for GSE risk could rise to 50% or $4 of capital per $100 of risk. Private corporate exposures are 100%.
Why would Fannie Mae and Freddie Mac be downgraded? Because the criteria used by Moody’s and S&P for sovereign ratings makes it impossible for a “private” obligor to achieve a “AAA/AA+” rating. No matter how much private capital an issuer possesses, even with a contingent $250 billion credit line from the U.S. Treasury, you are still not a “AAA” issuer. This means that the conventional mortgage backed securities issued by Fannie Mae and Freddie Mac would be downgraded as well. Hold that thought.
During her first testimony before Congress, Federal Housing Finance Director Sandra Thompson noted that once the GSE have raised the required $300 billion or so in private capital, they would need to have a conversation with Treasury about the preferred equity position held by the government. If the GSEs exit conservatorship, will the Treasury get par value for its investment? Another good questions you never hear discussed on Capitol Hill.
Rep. Blaine Luetkemeyer, R-MO, asked Thompson about the capital requirement under the amended regulatory enterprise capital framework put in place by FHFA. “Do you think $300 billion is the point at which the conservatorship can end?”
Thompson did not answer the question directly, but rather listed some of the things that need to be done once the GSEs have retained $300 billion in private capital. She said (h/t to Inside Mortgage Finance):
“When the enterprises meet their capital targets, that’s one component of exiting conservatorship. There are other factors that need to be taken into consideration. Certainly, conversations with Treasury about its senior preferred shares. Conversations with the Federal Reserve about certain policy issues, like single counterparty and what happens if the enterprises exit and what’s other significant institutions’ exposure to Fannie/Freddie stock.”
What Thompson did not say, however, because it would be too shocking to members of Congress, is that long before the US government begins to move towards removing the GSEs from government control, the Treasury must agree to continue guaranteeing the existing and future MBS issuance by Fannie Mae and Freddie Mac. Imagine how that change in the business model of the GSEs will impact the value of the private equity.
With, say, a “A+” rating from S&P for the two now “private” GSEs, the spreads on conventional MBS will widen, the market prices of the MBS will fall, and the cost of conventional loans to consumers will rise proportionately. Just call our colleague Warren Kornfeld at Moody’s and ask him what happens if the GSEs simply exit conservatorship with $300 billion in private equity capital (and zero corporate debt, BTW).
Allowing $7 trillion in conventional MBS to be downgraded by the major rating agencies would be a catastrophic event for the Treasury and the US housing market. As a result, most serious analysts who have looked at the GSEs understand that prior to release, Fannie Mae and Freddie Mac would essentially have to transfer full responsibility for the conventional MBS market to the Treasury. Instead of earning 50bp+ in insurance fees on MBS, the GSEs would need to pay the Treasury around 20bp annually to guarantee the secured mortgage debt.
Now, you are probably thinking, charging 50bp or more to consumers and giving Treasury 20bp is not a bad business. But here’s the rub: Who’s going to care about a guarantee from Fannie Mae with a “A+” rating? A: Nobody. Even at “AA,” the GSEs would be marginally competitive with the large banks, private mortgage insurers and also nonbank aggregators like Rocket Mortgage (RKT) and PennyMac Financial (PFSI). Keep in mind that the GSEs are nowhere near as efficient operationally as these private counterparties.
You see, there is this guy named Jamie Dimon. He’s got a bank named JPMorgan Chase (JPM) with a lead depository with a strong “AA” rating. He’s just below sovereign in credit terms. Why? Because rating agencies automatically give large, systemically significant money center banks a full notch of uplift in credit ratings. Why? Because JPM has access to the Fed’s discount window. In addition, Dimon has got over $2 trillion in core deposits. The GSEs have no internal liquidity, and no access to the Fed and by 2030 will have zero term debt in their capital structure.
Once the corporate debt is redeemed in 2030, the GSEs will basically be conduits with just enough working capital to buy loans and sell MBS. If you take the GSEs out of conservatorship without federal legislation, then the Treasury must cover all conventional MBS. The original issuers, Fannie Mae and Freddie Mac, become superfluous.
More, as and when the Treasury puts a public price on a federal credit wrapper for conventional MBS, why can’t JPM issue its own conventional deal, pay the Treasury 20bp and keep the rest? And that is precisely what will happen. Tell us again how the GSEs will make money post-conservatorship?
Going back to the inception, Fannie Mae always depended upon the federal guarantee for its debt to function in the capital markets. When it was created by Congress in the 1930s, Fannie Mae was essentially a federally chartered thrift owned indirectly by banks, a utility. In the 1970s, the Administration of Lyndon Johnson pretended to privatize the GSEs, but only in name. The government retained “dominion” over the assets, to paraphrase the US Supreme Court, voiding true sale and forever tainting the IPO of Fannie Mae and Freddie Mac as a monumental act of fraud by Congress.
In a perfect world, Congress would transfer responsibility for guaranteeing the conventional MBS market to Ginnie Mae and extinguish Fannie Mae and Freddie Mac, without any compensation to holders of common or preferred. The Uniform Mortgage Backed Securities (UMBS) platform would be opened to all issuers of conventional mortgages, aligning the conventional market with the market for government loans and Ginnie Mae MBS. Any issuer could sell conventional loans into an MBS without a federal guarantee in good times, but fall back on a Treasury credit wrapper in times of market stress.
Many of the operational and human resources at the GSEs could be migrated to the Federal Home Loans Banks, which become the liquidity backstop for the industry in a post-GSE mortgage market. As we noted in our latest column in National Mortgage News (“Washington is the problem in mortgage finance”), Director Thompson needs to reopen access to the FHLBs for independent mortgage banks (IMBs) that are helping to achieve the mission of the conventional market before the Fed induced recession overwhelms the secondary mortgage market.
Of note, some of our readers may have seen a press release a while back from an organization calling itself the “Capitol Forum” saying that Fannie Mae General Counsel Terry Theologides was leading a crusade against the acquisition of Black Knight (BKFS) by Intercontinental Exchange (ICE). We wrote about the deal in May in our Premium Service (“Does ICE + Black Knight = Shareholder Value?”).
We hear from the highest levels that the Capitol Forum statements about Theologides and Fannie Mae “were a complete fabrication.” Such is life in the swamp called Washington. But in June, Scott Olson of the Community Home Lenders (CHLA) did send a letter to the Department of Justice seeking an antitrust review of the proposed purchase of Black Knight by ICE – citing concerns about the impact on consumers and smaller IMB lenders.
As we never tire of reminding our readers, whether we speak of GSEs, zombie banks or large private monopolies, the public interest is rarely served but the private interests on and around Capitol Hill always benefit.