Declining US 10-Year Treasury Yield Means Another Treasury Draw is Almost Certain
Both Fannie Mae's (OTCQB:FNMA) and Freddie Mac's (OTCQB:FMCC) earnings are sensitive to interest rates. When Treasury yields tumble, both the GSEs record losses on interest rate sensitive derivatives.
In Q1, net fair value losses were $2.8 billion for Fannie Mae and total fair value losses were $2 billion (after-tax) for Freddie Mac. Fair value gains (losses) fluctuate with the movement of interest rates. Interest rate volatility results in volatile earnings quarter-on-quarter for both Fannie and Freddie.
|Net Fair Value Gains (Losses)||($2.8 billion)||$135 million||($2.6 billion)||$2.6 billion|
Fair value gains (losses) can be rather volatile and can shift from gains to losses on a quarterly basis depending on interest rates.
|Fair Value Gains (Losses) due to Derivatives (after-tax)||($1.4 billion)||$0.3 billion||($1.5 billion)||$1.5 billion|
|Fair Value Gains (Losses) due to Spread Changes (after-tax)||($0.6 billion)||($0.3 billion)||($0.6 billion)||$0.7 billion|
|Total||($2 billion)||0||($2.1 billion)||$2.2 billion|
At the beginning of Q2 (01-April), the US 10-year Treasury yield was above 1.7%. It ended the quarter (30-June) below 1.5%. With Treasury yields tumbling (due to Brexit, etc.), another Treasury draw is almost a certainty (in particular for Freddie Mac).
Just last week, the US 10-year Treasury yield closed at a record low of 1.375%. With yields remaining near record lows, the earnings of both Fannie and Freddie are certain to take a hit.
Very Small Buffer
At present, both Fannie and Freddie have a tiny capital buffer.
Residual Net Worth
|Fannie Mae (end of Q1)||$1.2 billion|
|Freddie Mac (end of Q1)||$1 billion|
What this means is that if Fannie posts a loss in excess of $1.2 billion and Freddie posts a loss in excess of $1 billion, they will both require another Treasury draw.
As shown in the table above, fair value losses alone contributed to $2 billion (after-tax) in losses for Freddie Mac in Q1. That means that fair value losses alone in Q1 were double Freddie's current capital buffer ($2 billion vs. $1 billion).
In Q1, Fannie posted comprehensive income of $936 million and Freddie posted a comprehensive loss of $200 million. That means that Freddie's Q1 loss was only $800 million shy of its current capital buffer ($200 million vs. $1 billion).
As is clear from the numbers, it wouldn't take much to push Fannie or Freddie over into negative territory (in particular Freddie).
Here's where we stand at present:
Aggregate Liquidation Preference on the Senior Preferred
|Fannie Mae (10-Q)||$117.1 billion|
|Freddie Mac (10-Q)||$72.3 billion|
Dividends paid to Treasury thus far have not reduced principal whatsoever. Under the current arrangement (Net Worth Sweep), principal is not allowed to be reduced.
Treasury Draws vs. Dividends Paid
|Cumulative Treasury Draws||Dividends Paid||Dividend Amount in Excess of Draws|
|Fannie Mae||$116.1 billion||$147.6 billion||$31.5 billion|
|Freddie Mac||$71.3 billion||$98.2 billion||$26.9 billion|
Fannie Mae has paid to Treasury $31.5 billion in excess of Treasury draws, and Freddie Mac has paid to Treasury $26.9 billion in excess of Treasury draws.
Another Draw would Complicate the Situation for Treasury
At present, despite having paid to Treasury dividend amounts in excess of draws received, the aggregate liquidation preference on the senior preferred has not been reduced at all.
Another draw would complicate the situation for Treasury because the amount drawn would need to be added to the liquidation preference. For example, if Freddie Mac were to require another draw of $2 billion for Q2, that $2 billion would need to be added to the $72.3 billion presently outstanding ($72.3 billion + $2 billion = $74.3 billion).
To not allow principal to be reduced whatsoever, but at the same time allow it to be increased despite the billions in dividends paid in excess of draws, would totally highlight the absurdity of the present situation. It would also complicate things when the conservatorships are unwound. Should Treasury draws prior to the Third Amendment be treated differently to draws after the Third Amendment? Should draws after the Third Amendment be deemed void because they were brought about by Treasury keeping Fannie and Freddie undercapitalized? These issues would need to be worked through.
Unilateral Government Action to End the Conservatorships
In light of these potential complications, I am of the opinion that there may be a slight possibility (however slim) that Treasury (in co-ordination with FHFA) will make a major announcement prior to Q2 earnings release either allowing for a recapitalization or an end to the conservatorships (less likely).
Q2 Earnings Release Date
|Fannie Mae||August 4, 2016|
|Freddie Mac||August 2, 2016|
I do not think the likelihood of this occurring is high, but let's not forget that Fannie and Freddie were placed into conservatorship on September 6, 2008. That's approaching 8 years. This has gone on long enough. This needs to end!
What Does this Mean for Investors?
If you have already built up your core positions in Fannie and Freddie, you don't need to do a thing. However, if you are currently sitting on the sidelines waiting for more favorable court developments, you might want to consider getting back in leading up to earnings release (at least, a small position). Any positive announcement could easily see Fannie and Freddie back above $6.
Disclosure: I am/we are long FNMA, FMCC.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
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