- Proposed insurer rules by the FHFA help to ensure that the government will not need to bail out the mortgage giant.
- The confirmation of Julian Castro as HUD Director has depressed the shares lately, but efforts to reform the GSEs do not have the political backing to do much harm.
- Reaffirm my previous price target of $14 per share on higher G-Fees and a recovering housing market.
Shares of Federal National Mortgage Association (OTCQB:FNMA) have been down lately leading up to the nomination of the new HUD director, but the FHFA has just proposed guidelines that may help the mortgage giant get back to being a normal company. Proposed guidelines on mortgage insurers help to ensure that the government will never again need to bail out Fannie Mae or Freddie Mac (OTCQB:FMCC).
When more regulation is a good thing
The Federal Housing Finance Agency (FHFA), the lead regulator of Fannie Mae and Freddie Mac, proposed new liquidity rules for mortgage insurers yesterday in a move that could help build support for the government-sponsored entities (GSEs). The new rules would require that mortgage insurers hold liquid assets worth at least 5.6% of their risk exposure to be able to insure loans backed by the GSEs. The proposal is well above the current 4% requirement and seeks to ensure that insurers have enough capital to back their policies in the event of another real estate collapse.
Naturally, the insurers are publicly fighting the proposed rules. CEO S.A. Ibrahim of Radian Group (NYSE:RDN) told Bloomberg that the guidelines, "create capital requirements that have the potential of shrinking access to the very segment of borrowers that we believe the government wants to expand home ownership for." MGIC Investment Corporation (NYSE:MTG) released a statement saying the proposal requires, "insurers to hold unnecessarily excessive assets with potential adverse effects on creditworthy borrowers."
While the proposal may likely change before implementation, it is a step in the right direction for the GSEs. Ensuring that mortgage insurers have sufficient capital in the event of a crisis means the government will not be called in to bail out the mortgage buyers again. If enough safeguards like these can be passed, support for shutting down the GSEs in Congress may quickly wane and the companies can get back to business.
The Administration pushes for reform
Shares of the mortgage giant have been under pressure lately, as the Senate confirmed San Antonio Mayor Julian Castro to lead the Department of Housing and Urban Development (HUD). Castro has been a critic of the two GSEs in the past and told lawmakers that he would support a plan by the Obama administration to close Fannie Mae and Freddie Mac.
Running against the GSEs has been popular in Washington since the financial crisis, but I doubt Congress or the Administration will find a workable model to reform the two companies. The most recent reform bill just barely made it out of committee, but could not find the support among Democrats to even be put to a vote. Director of the Federal Housing Finance Authority, Mel Watt, has actually helped the mortgage giants with an announcement earlier this year saying limitations on loan sizes would not be implemented and easing put-back rules for banks.
Efforts to shut down the GSEs run counter to the Democrats' desire to help low-income borrowers access to the housing market. The mortgage buyers, by virtue of their size and guarantee, provide an immense amount of liquidity to housing finance and ultimately help to lower rates. The two companies bought 61% of the residential mortgage-backed securities (MBS) originated in 2013, with banks holding the remaining 38% of originations. Private MBS issuers, the companies that the government wants to fill the GSE's role, accounted for less than 1% of the market last year.
Reaffirming previous recommendation and price targets
The proposed rules reaffirm my earlier recommendation on the shares of Fannie Mae and I am keeping my $14 price target. Increasing guarantee fees could help the company post earnings of $11 billion this year. Increasing the fees as high as 0.60%, to help bring private issuers back to the market, could increase net income to $17 billion.
Besides the longer-term upside on higher earnings, I think the stronger catalyst is in the evolution of stricter housing finance rules. A reform of housing finance, as with the proposed insurer rules, will help ensure that the government will not be needed as a backstop during a crisis. This could help take the momentum out of calls for an outright closure of the GSEs. With the slow recovery in the housing market and fewer calls for elimination of the two mortgage giants, the courts could be compelled to rule in favor of investors and overturn the net worth sweep currently in place.
While risks still remain for Fannie Mae, the government has no workable proposal for reform, and housing finance rules are slowly building a foundation for the company to stand on its own. At $4.00 each, the shares are significantly undervalued due to uncertainty and the government's net worth sweep of earnings. With a price target of $14 a share on higher guarantee fees and a recovering housing market, the upside is well worth the risk.
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