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Recent tweets by President Trump have revived talk of privatizing the two mortgage finance giants, Fannie Mae and Freddie Mac. While such privatization talk goes back to the Reagan Administration, many hurdles still remain to releasing Fannie and Freddie from government conservatorship. Because the future of housing finance in the U.S. is on the line, this is a marathon and not a sprint. Below are some of our thoughts:
On Fannie/Freddie privatization:
The government owns senior preferred stock with warrants that entitle it to 80% of the common stock. Analysts estimate that Fannie and Freddie combined net worth for the U.S. government could be roughly $300 billion. It is clear the Trump administration would love to repurpose the capital the government has tied up in the government-sponsored enterprises (GSEs); what is unclear is how quickly
The president started laying the foundation for releasing the GSEs from government conservatorship during his first term in 2019 by stopping the dividend payments from Fannie and Freddie to the U.S. The plan was to allow them instead to retain their earnings until they were recapitalized, after which time they would resume payments to the government.
At the current capital requirements -- outlined in the Enterprise Regulatory Capital Framework created by their governing body, the Federal Housing Finance Agency (FHFA) -- when you factor in the GSEs guarantee over $7.5 trillion of mortgages, they would be required to hold more than $325 billion of capital. Over the past four-plus years since the Trump administration paused the cash sweep from the GSEs, they have been able to retain roughly $150 billion of earnings and they have been more recently been earning roughly $25 billion per year combined. It is also important to note that while the government has paused the cash sweep, it still believes it will be entitled to the foregone interest over the last 6 years, which means the number it is owed continues to compound.
Assuming Freddie and Fannie keep earning $25 billion per year combined, this means to build up the rest of the capital shortfall just from earnings (assuming no capital requirement change), it would take another several years to meet the shortfall. This doesn’t factor in the additional dividends they still owe the government since the cash sweep change from 2019, which could push the timeline to upwards of a decade. This also doesn’t yet get into how to pay the government back the rest of the $300-plus billion. While taking the two companies public via an IPO eventually could be part of an option, it is also important to note that raising 300 plus billion from an IPO isn’t feasible and total IPO proceeds over the last three years combined only amounted to raising roughly $100 billion. It’s easy to see why the to the path to privatization is still a marathon and not a sprint.
There are several measures that can be implemented to speed up the process.
- Lower the capital requirement set forth in the Enterprise Regulatory Capital Framework to something less onerous. The current capital requirement is a Tier 1 capital ratio of 2.5% of adjusted total assets. If capital requirements are lowered to, say, 2% at the current earnings path, the GSEs are still a few years away from meeting their capital requirements. However, the more the capital requirement is lowered, the more we risk repeating the same cycle all over again. It has also been a very favorable environment for housing the past 10 plus years. I point this out because you can think of Fannie and Freddie as “flood insurance” providers in an environment where there haven’t been any floods since the GFC. In a recession people lose jobs, default on their mortgages more and this is where Fannie and Freddie’s guarantee fee insurance kitty gets tapped and losses occur.
- The government could speed up the process by forgiving the $300-plus billion it is owed by Fannie and Freddie. We believe Trump is a deal maker, so forfeting $300 billion of taxpayer money is a nonstarter and not a deal he would make.
- Fannie and Freddie could go public to raise the money to pay back the government. This is the long-term plan, but the value in the backing from Fannie Mae and Freddie Mac lies in the government backing and not Fannie and Freddie themselves. So you can’t take a company public until you have solved for what the future guarantee from these firms is… explicit or implicit. Otherwise, you are not maximizing the government’s stake.
There are other challenges to privatization:
- The cost of financing a home purchase will go up without a government backing. The last thing the voting public wants right now with 7% mortgage rates causing record unaffordability is even higher mortgage rates. This is why we believe the ultimate path out of government conservatorship (if ever) comes with a more explicit backing from the U.S. Government. But one might ask, if you are going to have an explicit backing, why ever let them leave government conservatorship and why not just sweep their earnings like the government did from 2009-2020. This is a valid point, and ultimately comes down to a decision similar to a choice faced by lottery winners. Does the government take the lump sum payment of $300-plus billion right now? Or collect $25 plus billion a year for life? While it probably makes sense to not take the lump sum payment, typically, members of Congress do not think out farther than their term. I will also point out that while the government doesn’t mind owning Fannie and Freddie now that they spit off $25 billion a year, in the next large housing downturn, they won’t like being on the hook like 2008, but they still have Ginnie Mae, which, as a full U.S. agency provides explicit government backing.
- If mortgages backed by Freddie and Fannie lose their explicit government guarantee, the buyer base for mortgage-backed securities (MBS) would change to one that is more risk tolerant – and one that would demand wider spreads in compensation. To see the major impact this could have, consider that the largest holders of Fannie and Freddie mortgages are U.S. banks. If you remove the implicit guarantee, it could lead to a chain reaction at banks and a capital shortfall if MBS were lower rated and they no longer got a 20% risk weight at banks. You would essentially weaken non Ginnie Mae MBS demand at banks, which, again, means other buyers would need to step in to replace the bank investors. Scott Bessent is a very intelligent man and will work with Bill Pulte, director of the FHFA to come up with a plan that isn’t that disruptive to the housing market or the economy. Bessent understands this process will take a while -- if ever.
So what happens from here?
The more time that passes, the easier the path to privatization becomes, because more capital is retained. But this process can’t be rushed. We expect that the end game will be years down the line, but ultimately we believe the explicit U.S. backing for Fannie and Freddie will be retained. We believe this would be the best outcome because it increases the likely global demand for agency MBS and results in tighter spreads and lower mortgage rates for the U.S. consumer. Since drafting this piece, Trump actually tweeted they would retain their implicit backing:
How did the market react to the tweets?
I mentioned that Ginnie Mae always has and, we believe, always will have that explicit government backing. A good way to tell how worried the MBS market is about the backing of Fannie and Freddie is to look at the price difference between Ginnie Mae MBS and Fannie MBS. The screen shot below shows the prices for various Fannie and Ginnie Coupon bonds (FNCL and G2SF, respectively), from 4% coupons to 6.5%. What you will notice is for many of the coupon swaps the price of the Fannie Mae Bond is higher than the price of the same corresponding Ginnie Mae Coupon Bond (coupon swap = difference between Ginnie price and Fannie price for a given coupon). This is because the MBS market does not give much weight to the possibility that the government backing will go away and the MBS trade more on expected prepayment speeds for a given coupon.
Fannie Mae bonds often trade at a premium to Ginnie Mae bonds.
Fannie Mae bonds often trade at a premium to Ginnie Mae bonds.
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What would we do if we felt the government guarantee was going away?
With an average daily trading volume of almost $3 billion, agency MBS are the second-most liquid market, behind only US Treasuries, according to the Securities Industry and Financial Markets Association.1 The beauty of this is that we can quickly swap our exposure from Fannie Mae to Ginnie Mae bonds if we ever felt this was a serious risk. As I mentioned above, right now in many cases Fannie Mae MBS trades at higher prices and tighter spreads than Ginnie Mae bonds, because prepayment speeds are generally faster on Ginnie Mae bonds across the board. This means that premium coupon Fannie Mae Bonds offer higher expected yields because prepayment speeds are slower. Conversely, you will see many of the below par bonds have higher prices on Ginnie Mae coupons relative to Fannie Mae because prepayments are once again faster, but this is a positive, as you pull to par faster and end with higher yields/returns.
Long story long, if we ever felt the backing from the U.S. government was in danger, you would see us more heavily invested in Ginnie Mae MBS. We believe Fannie and Freddie in the long term retain the government backing they have long had and Agency MBS holders can rest easier knowing the U.S. government will continue to be a backstop of last resort.
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