What post-conservatorship could look like for the GSEs

Last week, the mortgage finance industry finally heard from various government agencies about how we are to deal with the implementation, default reporting and resolution of the great mortgage payment holiday authorized by the CARES Act. Perhaps most important, the Federal Housing Finance Agency finally clarified that consumers may defer up to 12 months of interest payments on loans owned by the GSEs, Fannie Mae Freddie Mac.

Most recently, the FHFA clarified that homeowners who have sought forbearance on loan payments under the CARES Act may refinance a mortgage, but only if consumers meet a long, tortured list of requirements. All this guidance was welcomed by the industry, but there remain an awful lot of questions as to how forbearance loans will be resolved, and when lenders will be reimbursed for advances on delinquent loans and compensated for the work involved.

Even though the FHFA and the GSEs still have not yet rolled out a full response to the COVID-19 disaster, the agency’s conservative leadership thought this might be a good time for Fannie Mae and Freddie Mac to engage bankers to plan for an exit from federal conservatorship. The timing of FHFA Director Mark Calabria is impeccable, as usual. We find ourselves swimming through a stressed economic scenario where levels of unemployment and credit losses could be 2x the 2009 peak, when banks and private investors charged off hundreds of billions in loans.

Hannah Lang reports in NMN that "Fannie Mae and Freddie Mac said Monday they would begin the process of hiring financial advisers to assist the government-sponsored enterprises in creating blueprints to boost capital with the goal of exiting conservatorship." The capital requirements in the proposal were released on Tuesday. But of course, before we consider that, we must first decide what business lines we intend to retain when the GSEs are no longer government sponsored for the purposes of credit ratings.

Properly understood, the GSEs are buyers of loans, issuers of mortgage-backed securities and providers of guarantees to investors on these loans and securities. GSE business models have evolved over years of quasi-government support and monopoly pricing power. This support will continue to function only so long as the GSEs remain under federal control.

Once Fannie and Freddie emerge from conservatorship, the model is likely to change and dramatically, both for the GSEs and conventional lenders. But you need a business model to set capital requirements. Not only is Director Calabria preparing the GSEs to raise capital, but he must also help them decide just what they are selling to private investors in the way of equity returns and risk.

Specifically, if the FHFA intends to push the GSEs out of conservatorship without explicit capital support from the US Treasury, then the likelihood is that Fannie and Freddie will see their cost of funds rise and their profits decline. This reality may force big changes in how the GSEs deal with conventional lenders. And it may impact how the FHFA regulates the capital requirements of the GSEs.

"No crisis should go to waste and certainly the FHFA's director, Mark Calabria, knows it," writes market maven Rob Chrisman. "The jungle drums are saying more changes are ahead which could possibly shrink Fannie and Freddie's footprint even farther through changing execution. But rumors often prove untrue."

Chrisman speculates that as the FHFA tries to reduce the businesses of the GSEs while at the same time trying to woo investors on Wall Street for new capital, Fannie and Freddie may be forced to change how they buy loans from lenders. Specifically, the co-issue market, where a lender sells the mortgage note to a GSE and then sells the servicing to investors such as Lakeview, Pingora, Two Harbors and Roundpoint may be terminated with extreme prejudice.

Instead, Chrisman opines, the GSEs may eventually force lenders to sell their loan production with the servicing to the largest banks. This nightmare scenario fulfills the worst fears of the mortgage industry that GSEs privatization was really a way to hand the conventional loan market to the largest banks and nonbank aggregators on a silver platter.

"If an originator that doesn't service their own loans was cut off from selling loans to Fannie Mae or Freddie Mac through some type of co-issue execution," Chrisman writes, "and instead be forced to either start servicing loans themselves or sell to an aggregator such as Wells Fargo, Chase, AmeriHome, or PennyMac, well, that would change things overnight." Sure would.

Another possible change could involve the GSEs buying the loans and the servicing, and simply turn the banks and nonbanks in the conventional market into subservicers. Since the GSEs own the loans and the MBS issuance, and guarantee both exposures, it may make sense for Fannie and Freddie to just keep the full servicing strip and retain the excess servicing spread for the next rainy day.

Of course, looking at the market for credit risk transfer securities, one is not encouraged to believe that the GSEs can actually stand on their own as private firms. Pricing for the unsecured debt of the GSEs fell sharply after the March market selloff as did pricing for the CRT bonds. For now, credit default swaps spreads for the GSEs now trade inside the largest nonbanks. Will that be the case, one wonders, when we arrive at the end of conservatorship?

Imagine, for instance, if credit default swap spreads on the GSEs were to double post-conservatorship. Would the GSEs, the least efficient nonbanks, possibly survive as funding spreads rose and net margins contracted?

Both GSEs indicate that they do not intend to do additional CRT deals in the near future. That is probably a good thing. It is very unlikely that investors would be willing to buy new CRT paper anywhere near the midteens credit spreads that prevailed prior to March of 2020. Last year, Wells Fargo Securities showed implied guarantee fees of 10 bps for 2019 CRT deals vs 15-20 bps for 2018 vintages. Think 50-75 bps today, maybe.

Losses on levered CRT positions in March and April may have killed the market for CRT going out years. If the GSEs cannot issue new CRT securities, then how will FHFA fashion a capital plan for the GSEs that is credible in the private markets and to Congress? How should the cost of capital for Fannie and Freddie compare to say PennyMac, especially if the issuers and their new MBS are not wrapped by a sovereign guarantee?

More, if the market for CRT debt is indeed dead and buried for now, how does the FHFA suppose that Treasury will be able to get anything like book value for the sale of its $180 billion or so in GSE common equity? And with a shrinking footprint and rising capital costs in prospect for Fannie and Freddie? These and other questions, dear friends, will no doubt be answered in the fullness or time and in great detail by the FHFA. Stay tuned.