Fannie and Freddie Up Risk-Based Pricing

It is an understatement to say that there is risk in Fannie Mae (FNM) and Freddie Mac (FRE). But, just like any insurance type business there is also great opportunity in adversity. Two questions affect potential investors: Do these companies have enough capital to survive the current level of defaults? Will the opportunity to raise fees lead to sustained profitability going forward?

I have no way to analyze either company mathematically, so I will take an anecdotal approach. Just like Ambac (ABK) and MBIA (MBI), Fannie and Freddie can pay claims (principle and interest) over time for mortgages they guarantee. This would reduce the immediate cash outflow for claims. Also, recoveries on foreclosures might be greater than market prices for mortgage securities indicate. Funding costs for Fannie and Freddie might be increasing relative to treasuries, but funding does not appear to be drying up.

On the pricing front, aside from FHA, Fannie and Freddie are the only games in town. Both are adopting risk-based pricing and there is no competition to stop them. The market for non-GSA backed mortgages has almost completely disappeared. They can choose which types of mortgages to accept, and how much to charge based on loan-to-values [LTV] and credit scores [CS]. They have even reduced their loan-to-value tables by 5% for declining housing markets.

Fannie and Freddie have published their upfront fee schedules on their websites: Fannie Mae “Loan-Level Price Adjustment (LLPA) Matrix and Adverse Market Delivery Charge (AMDC) Information”. Freddie Mac “Overview of Recent Pricing and Credit Changes for Sellers” and “Postsettlement Delivery Fees”. All of these documents primarily refer to single family homes. Fannie’s document states that the fees are deducted from the purchase price for whole loan transactions, in essence an upfront cost to borrowers.

Fannie’s tables are far easier to interpret. Everyone is charged 0.25% of the loan amount for the Adverse Market Delivery Charge [AMDC]. There are two types of Loan-Level Price Adjustments: Credit Score (CS) and Cash-out Refinancing [COR]. CS charges range from -0.25 (elimination of AMDC) to 2.75% of the loan amount based on LTV and credit score. COR loans are charged an additional fee which is also based on LTV and credit score. COR charges range from 0% to 3% of the loan amount. The borrower’s upfront Fannie fees are the summation of the three charges.

Fannie gives an example of a 30 year, fixed rate loan with cash-out, a 640 credit score and 85% LTV. Before June 1, 2008 the upfront fee would be 2.25%, on or after June 1 the upfront fee jumps to 4% for the same loan. The AMDC stays the same at 0.25%. The CS charge increases from 1.25% to 1.75%, and the COR charge increases from 0.75% to 2%. Apparently, cash-out is now considered a big risk factor. In Florida, the same fees would only get you an 80% LTV.

It seems to me that better appraisals, limiting LTVs in declining markets, and risk-based pricing should give Fannie and Freddie a bright future. The only real issue is how much dilution current shareholders face as these companies thirst for capital.

Disclosure: Author is long both FNM and FRE.

Comments

[Signe]

The author doesn't appear to understand Fannie and Freddie's business. Paying out claims on defaulted mortgages over time is not an option -no one purchasing Fannie mbs or Freddie PCs expects to wait 30 years to get a return of principal. If either GSE stopped paying the full amount of unpaid principal and interest upon a mortgage default, the market for GSE-guaranteed mortgage-backed securiites would disappear as quickly as the private market did. Those securities are priced based upon certain prepayment speeds -none of which assume that borrowers will keep the same mortgage (or house, for that matter)for thirty years. Investors expect to receive any principal and interest due at the time of default in one lumpsum so that the impact on the securities is that of a prepayment. Creating mortgage-backed securities with potential 30 year tails would definitely increase the GSE's capital, because there would be no demand for their guarantees.