Last Friday, the U.S. Treasury announced several crucial changes to the Preferred Stock Purchase Agreements (PSPAs) of Fannie Mae and Freddie Mac.
The agencies' retained mortgage investment portfolios will now be wound down at a faster rate, increasing to 15% a year versus 10% earlier. This begins from a cap of $650 billion at the end of 2012. The portfolios must be reduced to $250 billion by the end of 2018.
The 10% dividend on outstanding preferred stock now in place will be subtituted with a quarterly sweep of all future earnings.
According to a report released today by Citigroup Global Markets, both the GSEs must submit an annual plan to limit taxpayer exposure to mortgage credit risk.
Based on the bank's analysis, the replacement of dividends will have a considerable positive effect on the GSEs' credit position.
Analysts said that both franchises have a much lower chance of exhausting their Treasury draw cushion. The new investment portfolio limits have a minimal effect as most of the asset drop can be done via a portfolio run down. Only small asset sales are needed for the agencies to reach their target portfolio size by 2018.
Dividend Replacement Strengthens GSE Credit Position
The 10% dividend on preferred stock has comprised a big portion of the Treasury draws made by both GSEs, analysts said.
The dividends' replacement take out a considerable drag on the agencies’ equity, strengthening their credit position, analysts explained. To find out the effect of this change, they estimated the net income under both the old and new PSPA terms.
Their income projections assume that g-fees will rise by 10 basis points a year to 60 basis points by 2016. Investment income and debt service are projected based on net interest yields in 2Q12. Under the amended PSPA scenario, analysts reduced the investment portfolio to comply with the new portfolio caps and take out the dividend payments.
Although the asset reduction results in only a small dip in investment income, the removal of dividends results in a big improvement in the GSEs’ equity position.
Analysts presented the projected size of the Treasury draw cushion for both GSEs. For Freddie Mac, the dividend payment would have meant added draws of $16 billion in the base case and $32 billion in the stress case through 2018. Under the new terms, Freddie does not need to draw more funds.
Meanwhile, under the old PSPA, Fannie Mae would have exhausted the treasury support in the stress scenario. With the elimination of dividends, they will only need to draw $22 billion more.