On Friday, August 17, the United States Treasury Department announced that it is changing the terms of its financial backing for Fannie Mae (FNMA.OB) and Freddie Mac (FMCC.OB). The new terms will accelerate reducing the holdings of the two agency mortgage companies, and will require the companies to pay the government any quarterly profits they earn. Prior to this new system, Fannie and Freddie were paying a 10% quarterly dividend payment to the U.S. Treasury.
This maneuver should be beneficial for mortgage originators, homebuilders and government debt in the near to mid-term, as it will delay more substantial reform of the two giant government-seized firms. This change in policy is likely at least partially designed to promote China's continued purchasing of U.S. Treasury bonds and agency issued residential mortgage backed securities.
Fannie Mae and Freddie Mac were both down considerably on the news, with each declining over 20 percent on Friday, and extinguishing some noticeable gains that both companies had during the first two weeks of August. See a 2012-to-date performance chart for FNMA and FMCC: (click to enlarge)
The Treasury also added that Fannie and Freddie's massive mortgage portfolios shall be wound down at an annual rate of 15%, up from the prior rate of ten percent. This will hasten the plan to reduce each agency's portfolio to $250 billion in assets by four years, to 2018. This move follows and coincides with housing indicators that have been showing signs of stability and even growth at levels not seen since the bursting of the housing-bubble. For example, in July, building permits reached their highest level since 2008.
If Fannie and Freddie were placed into receivership, which many argued should have happened in 2008 or 2009, the holders of agency RMBSs would have likely sustained significant losses. Rather than allow this, the agencies were placed into conservatorship in 2008. This present move is similarly likely to benefit owners of agency issued residential mortgage-backed securities to the extent that this structure should make it even less likely that the two mortgage giants will be placed into receivership in the near future.
As such, this policy modification should be seen as a benefit to agency mortgage REITs such as Annaly Capital Management (NLY), American Capital Agency (AGNC) and Hatteras Financial (HTS). These companies hold massive leveraged portfolios primarily composed of agency RMBSs, and pay out large dividends that are taxed as ordinary income. Agency mREITs are among the best performing asset classes within 2012.
While the market has already generally deemed the potential for agency default relatively improbable, this measure will only further lessen that potential. Moreover, and assuming that the perceived intended goal behind this policy change works, continued Chinese buying of such debt should also be positive for agency mREITs, as the demand should help provide price support to an already richly valued asset class. Much like U.S. Treasuries, agency RMBSs have been trading at historically high valuations and low yields.
Despite this policy change being generally positive for agency mREITs, the asset class still has a considerably higher risk profile than the usual. Spreads, or the margin between borrowing costs and the portfolio payout, are considerably lower than they have been in the past. This has also forced many agency mREITs to maintain growing leverage rates.
Going forward, if spreads continue to decline due to further interest rate reductions, dividend cuts are probable. Alternatively, if interest rates increase substantially, the leveraged portfolios could sustain considerable reductions to book value. Nonetheless, the Treasury's decision to change the terms of its financial backing of Fannie Mae and Freddie Mac should help mitigate these risks and make investors more comfortable with the prospective safety of their agency debt in the near term.