What's Next for Fannie and Freddie?

(Based on Wellington Management Viewpoints, August 2008)

What's significant about the recent legislation toward Fannie Mae and Freddie Mac?

With $5.2 trillion of guaranteed mortgages, Fannie Mae and Freddie Mac play a huge role in the capital markets. On July 13, the Treasury and Federal Reserve outlined a plan that provides access to the discount window and allows the Treasury to buy these companies' stock. On top of that, the recently signed housing bill includes provisions to ensure the security of these government sponsored enterprises (GSEs).

What is the GSEs' capital structure?

The GSEs' capital structure is fairly straightforward, with the vast majority of mortgage assets financed with unsecured debt. Short-term fixed rate unsecured discount notes are one-third of the capital structure, and long-term senior unsecured notes are two-thirds, and those are the main sources of funding.

There is now greater uncertainty concerning subordinated debt, preferred equity, and common equity following the Treasury and Fed announcement of the GSE plan to provide financial support, if needed. The Treasury can purchase equity to assist in any capital raising efforts. However, the amounts, timing, and mix of any capital sold to the Treasury remain unclear, as are implications for existing equity holders.

If the Treasury, for example, were to need to purchase equity in the companies, that could be materially dilutive to existing shareholders. On the other hand, if they are able to weather this environment, there is potentially significant earnings power coming out of the other side of this housing cycle that could, in turn, be very positive for the equities of the companies.

What are the upside and downside risks to the debt and equity portions of the capital structure?

Although chances are low that the GSE senior unsecured debt will be downgraded, given the explicit support provided by the Treasury, the joint default risk between the US Treasury and GSEs' debt is quite high. The potential downgrade risk is in the subordinated debt and preferred stock. As the companies report weak financial results, pressure will be put on capital instruments lower down the capital structure.

Will the GSE get downgraded?

The AAA rating is likely to stay in place on the senior unsecured debt, which is the vast majority of the GSE's obligations - in line with the US Treasury - due to high joint default risk. The subordinated debt and preferred stock could be susceptible to further downgrades just based on financial pressures and ongoing losses at the GSEs.

What are the earnings prospects for both entities?

In the near term, the earnings prospects are fairly subdued. These companies are expected to continue to report losses primarily related to the credit costs associated with the existing mortgage book. These losses will be somewhat offset by the revenue strength that they're deriving on the new business they're writing right now. The companies need more capital to grow in the current environment and profit from the wider spreads, which creates some vicious cycle. And at the same time, issuing new capital would be extremely expensive to existing shareholders. This creates a tug of war between how much capital they need to capitalize on the opportunities there versus being able to weather the credit storm.

If they have difficulty raising capital, what needs to happen to make these entities healthy again?

They will be able to raise capital because they do have a backstop now in this new housing bill. It just may be a
very adverse outcome for existing shareholders. What really needs to happen ultimately is for the housing market - or at least the potential downside in the housing market - to become more quantifiable. There are many estimates as to how much further housing prices are going to decline. As that range narrows, that will permit these companies to invest with more confidence going forward.

With what likelihood do you assess the capital raising efforts will take place over the near term?

Freddie Mac has committed to raise an additional US$5.5 billion in some combination of convertible, preferred, or common equity, and experts believe that they will be successful in terms of being able to raise the capital.
However, the price and the share count for Freddie Mac are unclear at this stage.

Fannie Mae does not need at this stage to raise additional capital, as they have raised around US$18 billion in the last 12 months. They could potentially cut their dividend if they needed to - Freddie Mac just did that today. Therefore, most of what has happened more recently with the GSEs is a favorable outcome for the parts of the capital structure above the subordinated debt, preferred, and common stock levels.

How are the markets reacting to the news?

The markets are worried. There is a lot of risk deleveraging , and the insecurity regarding Fannie Mae's and Freddie Mac's capital adequacy and their ability to raise equity has made people less willing to buy securities, which is reflected in the overall spread level. Mortgages currently are very wide by historical measures over the past 20 years; probably well over the 90th percentile for spreads.

Coupled with that, there is an asset class that has the full faith and credit of the US government, and that's the Ginnie Mae securities. The relationship between these two assets - Fannie and Freddie and the Ginnie Mae securities - has historically been very solid, with the average spread differential being about 10 basis points. However, most recently, that has changed, with the securities from Fannie Mae and Freddie Mac actually trading at a higher yield, a bigger concession to their Ginnie Mae counterpart, going from a 10 basis-points difference to 20 basis points, this 10-basis-point concession being reflective of the market nervousness. The new plan put in place to support and help the housing sector is supposed to lead to some renormalization in the US housing sector.

Is an extra 10 basis points of risk premium fair?

Some experts believe that holders of Fannie and Freddie are being overly compensated over the owners of Ginnie Mae securities. The way that many buyers at the lower end of the capital structure actually have access to mortgage finance right now is through Ginnie Mae; hence, the supply of Ginnie Mae securities over the past few months has grown dramatically, relative to what it had been over the last few years. That supply will have to be absorbed. With the new housing plan in place and a more focused and credible regulator overseeing the GSEs, one could make the case that Fannie and Freddie are more implicitly tied to the US government now than they ever have been.

How will the spreads to move in the coming months for agency mortgage-backed securities and agency debentures? Is the volatility expected to continue?

The volatility in the short run is expected to continue. The U.S. banking system is undercapitalized and would like to delever, but the levels at which the banks would be selling assets are far below what they view to be fair value. Therefore, the banks are not selling their assets. On the other hand, there's been a buyers' strike, as buyers are concerned about Fannie Mae and Freddie Mac and what will happen in the housing sector. Hence, volatility in the short is quite expected, more likely high than low, and it could be pervasive for a while.

What is the likelihood that these institutions will fail?

The experts believe that such likelihood is very low; in order to prevent failure, the government has many tools to step in and provide capital to these companies, whether it be in the form of debt or equity. However, the ultimate question is what happens to existing common shareholders in the event of such intervention. It would be a positive event ultimately for the more senior holders of the capital structure, but the equity shareholders would be adversely diluted, I think, under that scenario. However, if failing is defined as ceasing to exist, experts agree that it's a very low-probability event. If it means bankruptcy or liquidation, it's virtually nil.

If fail means nationalization, then such probability is higher. However, the government would clearly like to avoid that, given the implications for the country's balance sheet. However, it's important to remember that Fannie Mae was not a public company in the 1960s, and it was privatized in the 1960s, so it's not inconceivable that the private/public structure may not be ideal in this type of scenario.