GSEs’ exit from conservatorship estimated to take 15 years

It could be at least 15 years before Fannie Mae and Freddie Mac are released from conservatorship, and even then, the U.S. Treasury could keep its hooks in them, Keefe, Bruyette & Woods said.

January's amendment to the Preferred Stock Purchase Agreement with Treasury and the Federal Housing Finance Agency allowed the government-sponsored enterprises to build capital through retained earnings.

But even back then, FHFA Director Mark Calabria said that relying on those alone would not be sufficient to adequately capitalize the GSEs under his agency's November 2020 guidelines.

The GSEs’ 2020 retained earnings combined came in $273 billion short of the $315 billion in capital they would need to hold under the FHFA's final rule, said Bose George, an analyst at KBW. His calculations came from Fannie's year-end 2020 disclosure that it would need up to $185 billion in capital. Freddie did not make a similar disclosure, but George used Fannie's data to determine that Freddie would need $130 billion. As of Dec. 31, 2020, the two had a combined $42 billion in capital.

If conditions remain as they are now and Fannie stayed at its annual run-rate for earnings, between $10 billion and $12 billion, and Freddie remained at between $7.5 billion and $9 billion, it would take at least until 2036 for them to reach their minimum capital requirements.

George is not the only analyst who believes it will take a long time for the conservatorships to end.

"We believe the overarching considerations guiding GSE reform will be a strong preference on the part of moderate politicians on both sides of the political spectrum to avoid undue disruption to the cost or availability of mortgages, and the need for additional taxpayer support," said a report from KBRA Senior Managing Director Van Hesser. "Satisfying those conditions will require strengthening the GSEs' creditworthiness which, we believe, is underway, as well as lengthening the timeline for exiting conservatorship."

If it does take 15 years for the GSEs to build enough capital, George theorizes that the Treasury is likely to exercise its rights under the PSPA to convert its senior preferred stock to common stock.

By 2036, Treasury's liquidation preference will have grown in value to over $500 billion, so it will have little reason to freely give up the value of its position, George said.

"Based on KBW's earnings estimates and using a 10 times price to earnings multiple, George calculates a combined market cap of $206 billion in 2036," a KBW press release said. "Treasury already effectively owns 79.9% of that via its warrants. However, the conversion of its senior preferred could add nearly 20% ($40 billion) to its ownership."

As a result of the potential 2036 valuation of Fannie Mae and Freddie Mac's stock, George downgraded both to underperform with a $1 per share target for each; his previous targets were $2.50 per share for Freddie and $2 per share for Fannie.

On March 18, Freddie opened at $1.83 and Fannie at $1.88 per share.

While until now GSE reform has been interpreted as synonymous with recapitalization and release, under the Biden administration, this term might take on a different connotation, KBRA's Hesser said.

"A broader view of reform might include any combination of actions that accomplish a market which is stable, liquid, provides for affordable housing, and does not place meaningful risk to the taxpayer," Hesser said. "These goals might be served (and indeed are partially served) by structures that create, foster, as well as incentivize strong underwriting criteria and quality processes."

Those structures need to address risk sharing to the private market and reasonable risk-based capital requirements.

Significant, explicit and unambiguous federal support must be an ongoing part of whatever form that GSE reform takes, Hesser said: "Currently, conservatorship and explicit support outlined in the PSPA constitute a high degree of federal support."