GSE Reform: Looking At Sector-Specific Outcomes

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Includes: FMCC, FNMA
by: Long/Short Investments

Summary

The reform of government-sponsored enterprises Fannie Mae and Freddie Mac is one point of business that has maintained bipartisan support in Washington.

Like with any change, there projects to be “winners” and “losers” on the business front.

I discuss various verticals and related sub-sectors within the residential real estate industry and how they might be impacted by GSE reform.

Taking government-sponsored enterprises Fannie Mae (OTCQB:FNMA) and Freddie Mac (OTCQB:FMCC) ("GSEs") out of conservatorship remains an ongoing point of interest on Washington's political agenda. Politicians from both sides of the aisle have expressed interest in reforming the agencies and finding a solution to their operational independence outside the federal government.

Reforming the GSEs and how it would be done would have material consequences for the US residential mortgage market, which is estimated at around $11 trillion. (By comparison, US GDP is roughly $18.9 trillion).

Various verticals within the housing, banking, and lending industry would project to be impacted differently and would depend on the reform path taken, which is what I will cover in this post. The likelihood, benefits, or merits of any given reform measure is beyond the scope of this article.

Business Synopsis and Brief History

Most reading this are likely quite familiar with the circumstances surrounding the GSEs and how they got to their current form. But for those still new to the story, the GSEs were placed into conservatorship by the Federal Housing Finance Agency ("FHFA") on September 7, 2008, during the peak of the financial crisis, eight days before the fall of Lehman Brothers.

Each was entered into a deal with the US Treasury in what is known as a senior preferred stock purchase agreement ("PSPA"). Under the terms of the PSPA agreement, the Treasury provides capital to the GSEs whenever the net value of either Fannie or Freddie becomes negative (i.e., negative shareholders' equity).

They also are not permitted to retain capital on their own accord. Any excess earnings beyond their capital base is paid to the US Treasury. Through the PSPA from 2008 to 2016, Fannie has paid $154.4 billion in dividends while Freddie has paid $105.9 billion.

With respect to drawn capital, Fannie has taken $116.1 billion thus far under the terms of the PSPA while Freddie has drawn $71.3 billion. Fannie has access to an extra $117.6 billion under the Purchase Agreement, should it be necessary, while Freddie has access to $140.5 billion.

Overview

Fannie Mae and Freddie Mac finance approximately half of new residential and multifamily home mortgages and hold assets equal to 28.5% of GDP at $5.3 trillion. The GSEs are an integral part of the US economy given their federal guarantees on mortgage-backed securities and loan purchases and presence as a counterparty to various actors in the economy. This works to support various corporate activities, from mortgage banks, lenders, and insurers, and property owners, and homebuilders.

Currently, Fannie and Freddie possess more than $5 trillion of corporate and mortgage-backed security debt, which is subject to specialized restrictions. A substantive fraction is also owned by the Federal Reserve as a stimulatory measure to the broader economy.

Fannie and Freddie compete heavily against banks, private housing finance agencies, and private mortgage-backed securities issuers, and each of these entities has a strong vested interest in how GSE reform measures pan out.

Reform ideas among policymakers on the GSEs generally come in the form of reducing its need for public funding and ensuring adequate credit availability to benefit consumers. The likelihood of sweeping changes to the agencies remains low.

The arrow is likely pointing up on interest rates due to the fact that we're in the midst of a tightening cycle, though it's one that'll likely be fairly short, up to an overnight rate in the 2.00-3.00% range. Historically, 30-year mortgages have maintained a 100-500 basis point spread above the effective federal funds rate, with some exception based on unique economic circumstances.

(Source: St. Louis Federal Reserve)

The current spread, as of April 14, 2017, is 317 bps and the long-term average comes to 290 bps. The median is 328 bps. This means we're likely looking at average 30-year rates of somewhere around 4.9-6.2% by the time the Fed is at the top of its current tightening cycle. As of Freddie Mac's official March reading, we're currently at around 4.2% for 30-year fixed-rate mortgages, though this should come down with the 10-year Treasury coming down another 20 basis points in April.

Interest rates could rise if market liquidity decreases due to private-market participants' need to bear a greater share of the risk of the underlying loans, or the government lends less assistance to the housing finance sector moving forward. This would crimp the allure of Fannie and Freddie's mortgage-backed securities and other debt instruments. Even if the GSEs emerge from conservatorship with strong levels of capitalization, more stringent capital requirements could incent an increase in guarantee fees.

At the same time, interest rates could decrease if domestic and foreign demand for safe assets remains robust (as it is now, with the 10-year yield around 2.2%), market liquidity remains high, the Fed remains behind the curve with respect to increasing rates and the government continues to lend safety net support to the residential housing sector.

GSE reform is not a simple matter, and it'll be virtually impossible to alter the status quo with respect to its current role in the economy without producing winners and losers. Hefty lobbying will be involved to preserve and/or expand advantages currently afforded to certain verticals of the housing finance industry. However, the role of the GSEs changes, some businesses or entire sub-sectors will see their fortunes change for the better while other develop new challenges to their forward business prospects.

It is expected that the GSEs will be reformed at some point, and the Trump administration, led by Treasury Secretary, Steve Mnuchin, will have the intention to bring the issue into play before 2020. In terms of legislative priority, it is nonetheless subordinate relative to matters such as healthcare, corporate and individual tax reform, infrastructure spending, among other proposed initiatives.

How Reform Could Realistically Play Out

GSE reform is a complicated issue given the vast range of parties who have a vested interest in its outcome. There are a few main avenues of thought when it comes to GSE reform:

  1. Reprivatize but regulate. Regulation can come in the form of government-based insurance, where a certain amount of public funding is allocated to a type of safety-net pool. It can also come through a standard regulatory framework wherein the GSEs and other housing finance entities would be subject to various legal restrictions to supervise conduct and limit sector-specific and overall systemic risk. Under such rules, the GSEs could be subject to profitability restrictions, such as those applied to utilities.
  2. Unwind the GSEs and replace them with other housing finance entities and regulate through insurance or an explicit set of rules.
  3. Unwind the GSEs, but with no replacement.

Below, I run through how the unwinding of Fannie and Freddie could impact the US and its sovereign credit rating down to various private sector verticals within the residential mortgage industry.

Effect on US Sovereign Credit

It's unlikely any unwinding, partial unwinding, or re-privatization of Fannie and Freddie will materially impact US credit quality, which stands at Aaa at Moody's, AAA at Fitch, and AA+ at S&P.

Any liability currently held by the US government via the GSEs is likely to be transferred to either their replacement(s) as privatized entities or to US banks. The only way this process is likely to hurt US credit quality is if the risks associated with mortgages changed drastically, which is unlikely.

Under the terms of the PSPA agreements, first drafted in September 2008 and amended three times since, the US Treasury will recapitalize the GSEs should shareholders' equity come back negative. This is measured on a quarterly basis, as is standard for earnings releases of other corporations.

With respect to the GSEs, the US government maintains an undisbursed contractual commitment of 1.37% of GDP (i.e., the $258 billion in drawn capital) and an exposure of 1.00% of GDP with respect to accessible capital. For 2017, the GSEs are allowed to retain a $600 million capital buffer, with this number declining to $0 for 2018. The lack of a capital buffer next year means any drawdown would tap into taxpayer funds.

How GSE reform impacts real private residential investment remains to be seen. If reform increases the cost of residential mortgages through the main conduits of reducing market liquidity or diminishing capital accessibility, this could negate the ongoing recovery in residential investment as part of the US economy.

Residential investment as a fraction of overall GDP has been in a secular downtrend since a peak of around 8% in 1973. The peak of the last cycle in Q3 2005 came to 6.2% of GDP. As of Q4 2016, this has come to 3.5% of GDP, a modest bounce off the all-time low of 2.5% of GDP in Q3 2010.

(Source: St. Louis Federal Reserve)

Private Non-Bank Mortgage Lenders

An unwinding of the GSEs is likely to pose a challenge for private non-bank mortgage lenders, given the plurality of mortgages originated by these institutions have underlying guarantees by the GSEs or federal government. Even if Fannie and Freddie's influence in the mortgage market waned such that higher mortgage rates increased the overall profitability of mortgage lending, banks would soak up the majority of the market, limiting the benefit it would provide to private non-bank lenders.

These institutions generally rely on short-term/one-year secured warehouse revolving facilities to fund the mortgages they originate. Private non-bank mortgage lenders are limited by their weak funding profiles, which is a result of the following: (1) the industry is top-heavy with funding concentrated among a small number of lenders, (2) the short-term nature of the instruments by which mortgages are originated generate refinancing risk, and (3) asset quality is generally low in this sub-sector, which limits the ability to weather any unexpected events.

Hence, it's likely that GSE reform could negatively impact this sector. Should its revised role increase mortgage rates and increase the potential profitability of the residential mortgage lending, banks will uptake a majority of this market share and pose risks to private non-bank lenders.

Post-crisis, banks increasingly left the market predominantly out of concern for limited profitability due to an ultra-low rate environment. Additional complexities, including a stiffer regulatory environment and unprofitable legacy mortgages have also caused an erosion in bank participation. If the current administration reduces the regulatory burden of mortgage lending and rates on mortgages increase, this will bring greater competition into the sector, and the inevitable struggle to obtain adequate market share will largely offset any benefit to private non-bank lenders.

During times of market turbulence, liquidity in the mortgage market can dry up quickly, even for super-prime non-agency mortgages. If GSE reform undermine the liquidity in mortgage markets through diminished government backing, and force more private non-bank lenders to originate non-agency mortgages, the funding profiles of these firms would weaken and could disproportionately impact smaller players in this vertical.

Traditional Banks/Lenders

If an unwinding or re-privatization of the GSEs results in reduced credit quality for mortgage-backed securities (through a less amenable regulatory treatment), this would impact other financial markets. With respect to banks, such a divergence could have an adverse impact on liquidity and capital requirements.

In the above section, I stated that banks would have the advantage over private non-bank lenders should reform allow rates to increase and regulatory restrictions to decrease. If the regulatory treatment of GSE-related mortgage-backed securities ("MBS") becomes less favorable, this would directly work to increase banks' capital and liquidity requirements. This subjects them to perhaps greater stability but lower profitability. This would require a period of adaptation and regulators would likely give a multi-year period for banks to adjust their balance sheets to accord with the new rules.

Overall, higher mortgage rates would be a net positive to banks' profitability, assuming the spread between short-term rates increases in conjunction. This could nonetheless be offset if increasing interest rates slow the rate at which principal payments are made on loans and origination volumes fall due to the higher costs of mortgages. Should GSE reform incentivize banks to expand the quantity of longer-term mortgages on their balance sheet sheets, this could also materially expand their interest-rate risk in proportion to the increase.

If the special regulatory treatment of MBS spreads is retained, or if, at the very least, mortgage spreads increase at a rate higher than that of MBS spreads, banks could better generate income from mortgage loan sales. At the same time, if MBS risk increases due to the diminished degree of federal guarantees on these instruments, regulators will necessitate higher capital holdings. However, most reform plans are likely to continue to provide government guarantees on GSE-issued MBS.

Mortgage debt collection (i.e., mortgage servicing) would benefit from rising rates by reducing prepayment risk. How much of a benefit this would provide is unclear given slower prepayment rates could result in higher unrealized losses on pre-existing investments. The gap created by such would require the holding of additional capital for larger banks who are deemed to pose a systemic risk to the overall economy.

Moreover, banks hedge against the risks exposed to their debt collection business, motivated by capital rules provided by Basel III. If market liquidity decreases from a GSE unwinding, this would increase the cost of hedging their mortgage servicing positions, and work to offset any increased profitability that could be provided by wider mortgage spreads.

Federal Home Loan Banks

Federal Home Loan Banks ("FHLBanks") are regulated by the FHFA and collectively comprise 11 government-sponsored banks that provide liquidity to banks as a means of supporting home financing and community credit.

We can presume that an unwinding of the GSEs would create a more favorable lending environment for traditional banks assuming mortgage spreads increase (and/or increase at a rate greater than that of MBS spreads) and regulatory restrictions are reduced.

Banks rely on FHLBanks given their ability to obtain low-cost funding. Moreover, if a GSE wind-down reduces the volume of Fannie and Freddie debt in circulation - or impairs its credit quality - this could create demand for the debt of FHLBanks and further reduce the cost of funding and better provide an accretive funding source for banks.

FHLBanks lend out exclusively on a secured basis, where the majority of advances (i.e., lent out funding) is comprised of residential mortgage loans and associated securities. If a GSE unwinding pushes more banks into the residential mortgage loan business, FHLBanks will see their business prospects benefit in conjunction, given their capacity to provide funding.

FHLBanks have traditionally had a sound business given their government sponsorship. The stringency of their collateral policies, requirement for lenders to purchase additional equity as their borrowing increases, and latitude to secure secondary collateral in the event a lending partner's financial and/or liquidity condition erodes has provided stability and limited risks to its business model.

Private Residential Mortgage-Backed Securities Dealers

Private residential mortgage-backed securities ("RMBS") dealers would expect to be negatively impacted upon a GSE unwinding attributed to the reduced credit strength of mortgage-backed securities generally. Though most GSE reform scenarios afford some level of backing to MBS guarantees, increased mortgage rates and reduced standardization of loan underwriting standards could weaken private RMBS dealers, as well as undermine the ability to influence counterparties to attend to their obligations.

Without guarantees from the federal government, this would be at least a short-term hit to the RMBS market. Over time, it would be expected that private firms would fill the gap in the market. To get investors back onboard the MBS wagon, it would primarily take higher yields or greater levels of underwriting standardization, such as minimum credit quality standards, minimum levels of geographic diversification, and loan-to-value ratio limits.

Secondarily, investors may expect a catastrophic guarantee funded by mortgage borrowers and/or a continued high standard of underwriting quality from a federal agency that takes care of matters such as servicing, property appraisals, and loan documentation if private lenders weren't yet sufficient in these areas.

In the end, it will largely boil down to the level of cost efficiency for would-be borrowers. If private mortgage markets can beat out the costs of loans originated by the GSEs, the RMBS market would beneficially expand. This would expect to generate greater variety in the RMBS market by geography and credit profile and allow these securities to better weather economic shocks caused via regional impacts or adverse events disproportionately affecting lower credit-quality borrowers. However, RMBS markets are unlikely to benefit without government guarantee for the mortgages, and MBS spreads are likely to widen with the greater inclusion of loans with weaker credit profiles.

Diminished market liquidity, a reduction in credit availability, and higher mortgage rates would result in a drop in refinancing rates and slow or reverse the rise in home prices. This would become more problematic should wages stop growing (at least in nominal terms) and engender an increase in default rates.

For private RMBS dealers to benefit from a GSE wind down, they will need to be dealt a scenario that ideally expands market liquidity and credit access such that mortgage rates decrease, resulting in higher rates of prepayment in order to support the pricing among most forms of RMBS.

Single-Family Rentals Transactions

This pertains to a type of transaction rather than a specific business vertical, but if Fannie and Freddie were reformed such that mortgage rates increase, this would be positive for single-family rental ("SFR") securitization transactions.

Higher mortgage rates effectively increase the price of homes and push more would-be buyers into the rental market. Even if GSE reform leads to lower mortgage rates and increased home prices due to cheaper mortgage financing, SFR transactions could be a profitable niche among lenders if transactions are formed in such a way that hedges against lower vacancy rates and/or lower rental prices as more individuals choose to buy rather than rent.

Private Mortgage Insurers

An unwinding of the GSEs would expect to be a negative for mortgage insurers. Any wind-down of Fannie and Freddie that resulted in higher mortgage rates would work to reduce mortgage loan originations and push down premiums. This is a likely outcome should government-based support for the GSEs diminish and not be similarly transferred to other federal agencies.

Demand for mortgage insurance would be especially impaired if it were no longer compelled by regulatory circumstances as it is now. As is the case currently, mortgages originated by Fannie and Freddie with loan-to-value ratios greater than 80% necessitate add-on insurance. Private mortgage insurers have been used to satisfy this stipulation and generate demand for the product. GSEs could also be reformed in such a way as to push more of this requirement toward alternative credit enhancement solutions.

Private mortgage insurance markets have been challenged in recent years as Fannie and Freddie have become increasingly conscious of the way this passes risk to the private markets. Instead, the GSEs have increasingly focused on alternative structural finance products, such as securitizations done through Connecticut Avenue Securities (formed in 2013) and its complementary risk-sharing vehicle, Credit Insurance Risk Transfer ("CIRT"). CIRT works to transfer a portion of the credit risk on a pool of loans to a credit enhancement agency which then transfers such risk to reinsurers.

Businesses that participate in private mortgage insurance will nonetheless have time to focus more heavily in other business lines assuming the demand for their product decreases. Existing mortgage insurance portfolios are largely profitable and should remain so even years after any GSE revision occurs. The main exception would be if mortgage default rates increased to the point that its existing insured portfolio became unprofitable (i.e., recession, or adverse event specific to residential housing). The fact that private mortgage insurers are already aware that the structural, regulatory, and competitive environment is likely to become less favorable provides a head start.

Housing Finance Agencies

Housing finance agencies ("HFAs") are geared toward providing loans for sub-prime and lower-prime borrowers. HFAs are also a common originator of loans for those developing multi-family rental projects and for first-time homebuyers, who are usually younger and lower income. These entities receive loss protection from the GSEs to limit risk on their single-family and multi-family loans.

If GSE reform results in higher mortgage rates, HFAs could benefit but it will depend on the source of the higher rates. If higher rates are a consequence of lower market liquidity or higher origination costs, such that GSE-issued MBS costs go up from decreased credit quality, HFA profitability may be impaired in conjunction. Given HFAs primarily serve lower-income borrowers, who are traditionally most sensitive to changes in mortgage rates, increased borrowing costs are likely to put a lid on origination volume as housing becomes less affordable for this contingent especially.

Nonetheless, HFAs hold one unconventional advantage over banks and other more traditional lenders, given their ability to issue tax-free bonds. This provides a cost-effective source of financing that allows HFAs to undercut mortgage loan costs provided by its competition. If the applicable tax rates are lowered through corporate tax reform, if and when it gets done, this could change the degree of competitive advantage for HFAs. But as mortgage rates rise generally, the disparity between the cost of taxable and tax-exempt rates would increase.

It would also depend on how mortgage rates rise relative to the rates on their existing bond issuances. Mortgage rates rising at a faster pace than existing bond issuance rates would be a positive for these institutions.

With Fannie and Freddie MBS rates likely to increase upon GSE revision, it's likely that HFAs would transfer more of their loan production to bank loans, FHA or other government-backed loans, private mortgage insurance, or have more of their bonds backed by Ginnie Mae-issued MBS.

Homebuilders

It's widely expected that homebuilders would be hurt by GSE reform.

Homebuilders rely on leverage to build real estate assets. When mortgage rates go up - as they would be likely to do if the GSEs' role in the economy were to be revised - this increases the costs of development. This can also logically extend to building/material product suppliers and the underlying commodity markets themselves.

Higher rates limit credit access and provides a lid on the extent to which this debt can be used to generate an ROI on new building projects. Higher rates also diminish the number of available buyers and those who qualify for mortgage loans. The most price-sensitive would be predominantly affected as well as those currently paying on adjustable rate mortgages. Any excess supply from overbuilding during a low-rate environment may also result in inventory write-downs.

Homebuilders' financial arms would be likely to suffer, which typically provide mortgage financing, closing services, and title insurance. Origination volumes would be likely to decrease and defaults would increase as rates increase.

Home equity lines of credit would also diminish, which are typically used for home repairs and upgrades, hurting building material suppliers. It's also highly contingent on the type of repair. Discretionary product suppliers, such as the installation of outdoor recreation centers, would be most adversely impacted while nondiscretionary upgrades (i.e., plumbing, siding) would be the least impacted.

Adverse impacts would be most heavily felt among homebuilders who specialize in lower-cost homes outside the most robust housing markets. Those who cater toward higher-end homes in the top housing markets would likely be the least affected.

Multifamily REITs

Multifamily REITs would likely be adversely impacted by GSE reform given (likely) decreased credit quality would impinge on the ability to refinance mortgage loans, particularly during less favorable macroeconomic environments. Multifamily rentals tend to be less volatile than single-family rentals, which has been largely driven by mortgage funding availability provided by GSEs and high rent demand.

Any impact on Fannie and Freddie with respect to multifamily units is likely to impact the buyers of these properties most heavily (i.e., borrowers). The GSEs' financing support of the multifamily market is generally more favorable than that provided by private lenders and offers cheaper financing rates than those seen in the commercial MBS market, which is also subject to periods of volatility or limited access during economic contractions. If the accessibility of credit via Fannie and Freddie is weakened by reform measures, it's unlikely that borrowers could push off any increased costs over to lessees, given the rent market is normally equilibrated by regional-level supply and demand forces, or in some cases subject to local government regulations.

The effect of GSE reform would also affect parts of the multifamily market differently. "Multifamily" is an umbrella term for any form of housing with five or more apartments/units within a single property, but makes no account for quality or geography.

As mentioned in previous sections, entry-level buyers are the most likely to suffer from a revision of Fannie and Freddie's role in the economy unless the government's backing of GSE loans is transferred through alternative government entities. REITs with high exposure to lower-quality multifamily rentals in secondary metropolitan areas would be subject to the greatest volatility, while higher-end and luxury rentals in the top metropolitan areas would likely be subject to the least amount.

Miscellaneous Impacted Businesses

If the private sector were to take over a greater portion of the mortgage business, this will increase demand for specialized data and niche financial services, such as mortgage risk management, mortgage processing, actuarial/insurance services, collateral valuation, securitization, residential real estate brokerages, and credit bureaus and collection agencies.

Conclusion

Based on the individual sections above, it's clear that GSE reform is likely to produce "winners" and "losers" among the various industries and corporate offshoots tied to the residential real estate market. US consumers as a whole could potentially be left worse off via the potential disruption of market liquidity and limited access to credit with government backing - that is, if privatization efforts and their potential ramifications aren't properly thought through. This is what makes the topic of GSE reform such a highly contentious and politically charged topic.

Current US Treasury Secretary Steve Mnuchin has stated the current administration's intention to take on the task despite its current backseat to other legislative priorities. Although we do not know the precise direction GSE reform will take I outlined some potential winners, losers, and those not too tangibly affected.

Among the main potential winners:

  • Banks and traditional lenders
  • Federal Home Loan Banks
  • Certain data analysis and financial services that would soak up the need for additional support solutions within residential real estate

Those more neutrally affected:

  • US sovereign credit
  • Housing finance agencies

Among the main potential losers:

  • Private residential mortgage-backed securities dealers
  • Private mortgage insurers
  • Multifamily REITs

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

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.

Editor's Note: This article discusses one or more securities that do not trade on a major U.S. exchange. Please be aware of the risks associated with these stocks.

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