By Ben Edwards
Freddie Mac reported a net loss of $354 million in the first quarter of 2016, following a $475 million loss in the third quarter of 2015. Net income was $2.16 billion in the fourth quarter. Both losses were attributed to mark-to-market moves on interest rate hedges that soured, something that market participants seem sanguine about for now. But any further losses could fall on taxpayers and potentially hasten the pace of housing finance reforms.
When the government placed Freddie Mac and Fannie Mae into conservatorship in 2008, it demanded both mortgage buyers hand over all profits to the state and shrink their capital reserves to zero by 2018, reducing their ability to soak up losses and potentially forcing them to call on the Treasury for further bailouts. Freddie Mac can draw an additional $140.5 billion from the Treasury as part of the conservatorship.
“If they draw, that could create a crisis in confidence,” says Tracy Chen, head of structured credit at Brandywine Global. Such an outcome might speed up the discussion of reform and potentially see Freddie Mac released from conservatorship and allowed to recapitalize, though Chen says it is unlikely anything drastic will happen during an election year.
Yet Freddie Mac only narrowly avoided having to draw on the Treasury this time, and with its capital buffers depleted, any further losses could force the issue.
“At some point they’re not going to have any capital to withstand any type of losses, and it’s questionable how the government is going to respond to potentially having to cut a cheque every quarter,” says Jason Callan, head of structured credit at Columbia Threadneedle Investments. “But up until this point it’s been a massive windfall for the government, and the government is always incredibly slow to let go of anything that has positive cash flow.”
While that profit sweep might have tempered any urgency to reform – together Freddie and Fannie have handed the Treasury almost $250 billion, roughly $60 billion more than they have received in bailouts – a lack of consensus in Washington about what role the government should be playing in the provision of housing finance has also been a factor.
“There’s a huge political disparity based on whether they should remain a provider of affordable housing or whether they should scale back, and that’s really where the discrepancy lies,” says Jeana Curro, an agency MBS strategist at Deutsche Bank in New York. “When the GSEs (government-sponsored enterprises) were profitable, it was very easy to kick housing reform to the back burner.”
Some lawmakers might also be reluctant to shake things up, given that the housing market remains in relatively good health. “Trying to reform something that has done a pretty good job at performing and is something you don’t want to break probably becomes a lower priority,” says Dmitri Rabin, global RMBS and covered bond strategist at Loomis, Sayles & Co in Boston. “The fundamental business is sound, and that makes people less willing to go in and start changing things dramatically.”
Some reforms are already underway. Both mortgage buyers have started issuing bonds that shift credit risk from taxpayers to private investors. And plans to introduce a single security so that Freddie Mac and Fannie Mae bonds are not competing on price should be ready by 2018.
“The GSEs serve a really good purpose in their current form, and a lot of people in [Washington] DC recognise that,” Callan says. “At a minimum they are a standard bearer for the origination process, and they’re continuing to look to capital markets to sell off risk. If rational heads prevail they will continue to move towards a more intermediary role.”
Curro believes Fannie and Freddie, for now, remain a critical part of the government’s housing market plans. For instance, the Federal Housing Finance Agency is talking about using the GSEs to come up with a new programme to extend credit to underwater borrowers to help them refinance high loan-to-value mortgages, she says.
“It’s hard for the government to roll out these housing initiatives if it doesn’t have some kind of provider of mortgage credit under its umbrella,” says Curro. Fin-tech firms expanding into mortgage lending will also hope the GSEs continue to be in a position to buy loans. In May, marketplace lender Social Finance (SoFi) said its mortgage unit had been approved as a seller and servicer with Fannie Mae, though investors say SoFi, and others like it, are unlikely to become heavy suppliers of new mortgages.
“The core impetus of what SoFi is trying to originate (jumbo loans) is going to be collateral that falls outside of the average balance bands that the GSEs guarantee,” says Callan. “And there are not many others trying to move into this space.” Even so, some investors are not impressed by the potential of marketplace loans winding up in Fannie or Freddie securities. “Marketplace lending is a frontier and is very loosely regulated,” says Chen. “I don’t think GSEs should venture into that area.”
But Curro is less concerned, given that the GSEs will not buy mortgages unless the loans meet their origination standards. “The fact that Fannie Mae approved SoFi isn’t a surprise,” she says. “If somebody wants to deliver loans to Fannie Mae that are eligible to be used in Fannie Mae securities they have to meet all the guidelines, so it’s less important who is originating the loans.”