Amidst ongoing pressure to meet its capital requirements, Fannie Mae released its February volume report last week characterized by a smaller retained portfolio as well as a less active guaranty business. MBS sales from its retained portfolio increased to a record $9.5 billion from $6.4 billion in January, with mortgage spreads to Agencies remaining tight through the first half of February. Mortgage-backed analysts from JPMorgan Securities noted that the last two months of MBS selling are comparable to the sales from all of last year. Meanwhile, the firm's equity researchers said that gains from mortgage sales and the benefit from rising interest rates have probably helped the GSE in making considerable progress toward attaining the capital target set by the Office of Federal Housing Enterprise Oversight.

Separately, Merrill Lynch also noted Fannie's current inclination to sell MBS. "With Fannie Mae still under pressure to boost its capital requirements, we expect the GSE to continue shrinking its portfolio over the next few months, largely through runoff," analysts wrote. "However, it is increasingly clear that the GSE is far more open to taking advantage of rich valuations and selling MBS, especially as recognizing any gains on sale helps generate incremental core capital."

Fannie Mae reduced its capital needs by roughly $610 million last month because of a $16 billion retained portfolio reduction and an assumed $12 billion decline in period end liquid investments - equal to the reduction in average liquid investments - that was, in part, offset by growth in net MBS. JPMorgan equity analysts think that the asset sales were made up mostly of higher coupon mortgages that are expected to produce gains as well as enhance capital.

Meanwhile, JPMorgan MBS analysts said last Tuesday that considering Fannie Mae's published commitment levels as well as the 40% rise in paydowns for March, they expect the retained portfolio might shrink by an additional $15 to $20 billion this month, while noting that it has already plunged by $38 billion from its peak. Fannie is expected to maintain a measured de-levering pace through September - with an additional $100 billion of de-levering expected - which is the deadline for reaching its capital target. Analysts stated that this has been the largest net fixed-rate MBS supply source, and they expect it to steadily weigh on the MBS sector. This should not result in "gapping market moves," which are more a product of concentrated bank holdings.

UBS analysts reported that too many market participants viewed Fannie's volume summary in a bad light, noting that Fannie's purchases roughly equaled its sales - the GSE made $9.4 billion in security purchases while selling $9.5 billion - shrinking its portfolio by $15.6 billion, or 19.1%, including prepayments. "We believe that this information should have been taken positively, as it indicates that a huge amount of the portfolio reshaping which Fannie Mae has to do by Sept. 30, 2005 has already been done," UBS analysts said.

While Fannie has done most of the necessary adjusting by now, portfolio shrinkage is probably going to continue, because it does not make sense for Fannie, or even Freddie Mac, to grow. "In the next few months, we do believe that Fannie will continue to shrink because spreads are very tight," analysts wrote, noting that the GSEs would not be willing to grow when the OAS on their assets and liabilities are very similar. Aside from this, "further shrinkage allows Fannie to establish a capital cushion, not a bad plan when under siege," analysts stated.

Like Fannie, rival Freddie Mac is also expected to shrink its portfolio going forward. Data shows that Freddie has $2.5 billion in excess capital that could be used to support about $100 to $125 billion in new mortgage purchases if Freddie chooses, said UBS. But Freddie has chosen to shrink, due to the tight spreads, as evidenced by the 10.6% Freddie portfolio contraction in January, a trend expected to continue in the near term.

Fannie also reported last week that gross MBS outstanding remained flat at $1.9 trillion. Private label MBS share also remained at 49%, less than 50% for two consecutive months. JPMorgan equity researchers expect rising rates combined with a flattening yield curve to result in the GSEs having a greater share of the MBS market, but there is also the specter of liquidations increasing slightly in March with the settlement of refinancing applications, which could negatively impact near-term growth.

Another notable aspect of the February report is the drop in portfolio purchases, decreasing to $9.4 billion in February from $11.1 billion in January. Merrill analysts added that the market does not usually give that much significance to purchases as they typically lag commitments by one to two months. But in February, Merrill estimated that some of the portfolio purchases might have been derived from commitments made in the same month, as the previous one to two months of commitments were probably not significant enough to account for all the purchases.

Merrill analysts believe this trend is probably going to continue. "In our view, accounting considerations may make it less likely that Fannie Mae makes purchase commitments too far forward, especially in periods when rates are expected to be rising (or volatile)," theorized Merrill analysts. The majority of the $2.4 billion in SFAS-149 related charges the GSE might recognize in its accounting restatement already happened in mid-2003, when its commitments were settling two to three months forward in a scenario where rates increased by more than 100 basis points.

Interest rate risk is still very low with Fannie's duration gap averaging zero months in February compared to negative one month in January. "It is very important for Fannie to keep its interest rate measures as low as possible while it is under such tight scrutiny although this is likely to increase the cost of hedging and may put some downward pressure on margins," JPMorgan equity analysts wrote.

Fannie Mae also reported that delinquencies trended upward last month for both credit enhanced and non-credit enhanced loans, due to the combination of seasonality, a decreasing denominator and portfolio seasoning.

In a related development, Fannie Mae announced recently that it would miss the regulatory deadline for filing its 2004 financial report and might even have to record an additional $2.4 billion loss. Additionally, falsified signatures that were discovered at the firm raised the possibility that some company employees might be guilty of criminal activity.

Copyright 2005 Thomson Media Inc. All Rights Reserved.

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