That reform of the Freddie Mac and Fannie, the two government sponsored enterprises (GSEs) currently in government conservatorship, must get done and get done soon is pretty clear in a picture of their finances painted by Moody's Investors Service. The illustration is part of a special comment issued by the company on Monday; "The GSE Debate and the U.S. Mortgage Market."
If the GSE model is to be preserved the report says, the GSEs would require far more capital and the risk premium on their debt would be much higher, necessitating either much higher mortgage rates or much more financial backing from the government. The choice would be between significantly contradicting the government's policy of providing affordable home financing or defeating the objective of encouraging maximum private sector participation in the mortgage market.
Under existing conservatorship arrangements, Fannie Mae will ultimately draw between $147 billion and $232 billion and Freddie Mac between $71 billion and $104 billion from the Treasury by the end of next year. The senior preferred stock that will be held by the government will obligate Fannie to pay annual dividends of $14.7 and $23.2 billion and Freddie to pay between $7.1 billion and $10.4 billion. Fannie's annual earnings have never exceeded $8.1 billion and Freddie has earned over $7.1 billion only once, in 2002. This unsustainable model will require reform and ultimately action by the legislative and executive branches of government, a political process that Moody's says will not be easy and it may be the credit markets that will force the issue.
Moody's believes that major reforms are unlikely to be adopted until after the 2012 presidential election and that it is likely changes will be phased in over time. "While a political solution may not be quick in coming, the credit market will at some point expect clarity on the role of Fannie Mae and Freddie Mac by demanding a greater risk premium on their obligations, thus increasing their borrowing costs and raising the cost of mortgage credit."
While reform could take many directions, Moody's sees government support of existing senior debt through maturity and the resulting continuation of substation of U.S, sovereign debt rates for these obligations to be most likely. Without such support, continuation of the current Aaa rates would be inconsistent. While the path of reform could change and thus the ultimate outcome does remain uncertain, Moody's believes that any change in the GSE's current situation is unlikely to occur before January 2013 which puts it outside of Moody's 12 to 18 month rating's horizon and thus the ratings outlook remains stable.
If progress on reform occurs more quickly, however, the stable outlook could turn to negative. This would happen if political consensus-building grows around a plausible scenario that diminishes the importance of the GSEs and eliminates or reduces government support. One example would be to consistently reduce the conforming loan limit over several years, as recommended in a White Paper from the American Enterprise Forum released last week, coupled with a plan to recapitalize the companies without explicit ongoing government support for legacy bondholders. This would be inconsistent with continued Aaa ratings.
The report sees reform finally taking one of three avenues; privatization, permanent nationalization, or a hybrid of the two. Privatization would mean the removal of all government support from the housing finance market. The GSEs would be wound down or their assets sold and their importance would decline. Under this scenario the legacy debt ratings could be significantly reduced if both explicit support and recapitalization were not an implicit part of the plan. Moody's believes that this plan would result in a trade-off with the cost of credit rising and access to it declining as alternative sources of credit would expect higher returns for increasing their exposure to long-term fixed rate mortgages. This would reduce the availability of 30-year fixed rate mortgages and credit access would likely be uneven across geographies and less available during periods of stress.
Under permanent nationalization the government would absorb GSE operations, possibly into an agency such as Ginnie Mae and would guarantee the principal and interest of any securities of the entity. This would also marginalize the GSEs so ratings would be driven by the level of support and/or the financial profile of the entity in which the legacy debt resides. Moody's believes that this would achieve the government's aim of providing affordable and accessible mortgage credit but at such a price, absorbing a $5 trillion market that it is unlikely to happen.
A hybrid reform solution, something between privatization and nationalization, could take two possible forms.
Option one would be a model similar to the current one with the existing GSEs being transformed into GSE-like entities that aggregate mortgage credit and interest rate exposure either by owning the loans or guaranteeing security. These entities would have their own franchise funded by their own capital and debt and their activities would likely be restricted as would their investment portfolios. Under this scenario the legacy debt might be removed and put into a "bad bank" or the GSE-like entity(ies) could be recapitalized and operations continue with new debt undistinguished from legacy debt.
This option would be easy to implement but difficult to sell politically for the same reasons - little change from the current model. The entities would still aggregate large amounts of credit risk through their portfolios which would make standardizing easier and translate into lower rates for consumers but lower yields for investors. While this would meet the objective of affordable and accessible credit it carries considerable taxpayer risk.
Option Two would involve the creation of many private GSE-like entities which would securitize loans in MBS that are ultimately guaranteed by the U.S. government. The guarantee would become effective only after the entity's own resources were depleted. The underlying loans would not be guaranteed. The entities would pay a fee for the guarantee, effectively making it catastrophic insurance. The types of mortgages they could underwrite would be restricted by the government or regulators and legacy debt would be removed.
This second hybrid option appears the more likely as it is feasible politically and meets the government's objectives to some extent. The ownership and guarantee structure would spread risk of loss across all capital providers and reduce systemic risk
Discussions about the alternative ownership structures under both of these options has been vague but has included cooperative, utility and not-for-profit entities. Under the first model the credit profiles of the one or two entities would likely incorporate an assumption of government support and could therefore attain an Aaa rating. Under the second scenario this assumption would not be likely and so this rating would not be retained.
Moody's report also looked at the impact of reform on the other major players in the mortgage market.
Banks are already highly concentrated in the residential mortgage business. The top three banks originate more than 56 percent of residential mortgages, service nearly half of these, and own approximately $1.2 trillion of agency MBS. They could, therefore, replace almost 25 percent of the GSE mortgage funding by replacing run-off of MBS with mortgage loans. This would require substantial addition capital and would increase the concentration of residential mortgages.
Mortgage insurers will be directly impacted by GSE reform. If that reform eliminates the requirement for credit enhancement of high LTV loans it would negatively affect the industry which is already weakened by credit losses. The structure and timing of reform are critical; a long transition would allow insurers to continue their profitable business model and build capital while seeking new business opportunities.
The demand for residential mortgage-backed securities (RMBS) has been limited the last few years and is unlikely to increase until housing prices stabilize and other factors are introduced:
- Greater transparency on the associated risks;
- Clear mechanisms for enforcing representations and warranties;
- Improved creditworthiness of the entities making the representations and warranties;
- Greater clarity on the implications of financial reform laws generally and GSE reform specifically
Covered bonds will probably be promoted through legislation. A robust covered bond market would provide banks with an additional source of financing mortgage originations but legislation such as already in force in Europe that clearly defines how these bonds would be handled in a bank default is necessary. The size of the market is also limited by competition from the Federal Home Loan Banks.
