Last week Fannie Mae announced its capital restoration plan and released its monthly volume summary, marked by continued retained portfolio declines. Analysts said that they expect this diminishing trend - with even larger drops - to continue until September, the month Fannie Mae has to reach its new capital target, which the Office of Federal Enterprise Oversight extended for three months to give the GSE more leeway.
Fannie announced two components to its capital restoration plan. The first is to manage its total balance sheet asset size by portfolio shrinkage, which will be done mainly through mortgage liquidations. The purpose of this is to limit overall minimum capital requirements. The second is to increase core capital via retained earnings, which includes cost-cutting efforts to augment capital.
In its monthly volume summary, Fannie also stated that retained portfolio or MBS sales for January reached $6.4 billion (the highest ever) - considering sales on a normal month usually amounted to $1.5 billion - while forward purchase commitments dipped significantly to $797 million from $9.3 billion the previous month. Although Fannie Mae did not disclose specific terms of the securities that were sold, equity analysts from JPMorgan Securities said that it is believed they were higher coupon MBS, which should mean sizeable gains for Fannie. The retained portfolio also decreased by $13.8 billion to $890.8 billion.
MBS analysts from JPMorgan added that judging from January sales, they are anticipating Fannie to slightly hasten its selling activity in the coming months by having $7 billion to $8 billion a month in explicit sales until its Sept. 30 deadline. The retained portfolio is also expected to shrink by to $120 billion to $150 billion over this period. Analysts said, however, that overseas and bank demand should comfortably absorb this level of net supply. "However, it leaves little room for error, especially with spreads at tight levels," researchers wrote. Their view of the mortgage basis, as of last Wednesday, has thus shifted from a tactical overweight to a small underweight as steady GSE selling as well as tight spreads are expected to weigh on the market.
In an earlier report, JPMorgan MBS analysts said that Fannie could possibly issue more preferred debt or sell premium securities out of its retained portfolio to reach its required capital target. Analysts assumed that paydowns alone would not be enough to achieve the capital target by the deadline. They also noted that some market players have not been clear about the effect of paydowns on core capital, explaining that paydowns on par securities do not really result in an increase in capital but actually lead to a drop in the minimum capital target. Considering that there could be gains booked on premium MBS held in available-for-sale accounts, the sale of these assets result in both a capital increase, from realized gains, as well as a lessening in leverage or a lower capital target. For instance, JPMorgan theorized that Fannie Mae would need to sell roughly four times as many 30-year 5s as 6s to reach the same capital target.
JPMorgan previously estimated that Fannie Mae would need to sell the equivalent to roughly $75 billion in 30-year 6s to reach its capital target assuming that monthly paydowns would be approximately $13 billion and without a material fourth quarter change in core capital. Analysts also initially suggested that Fannie might also issue more preferreds as opposed to delevering, although with preferreds now accounting for about 20% of capital - considered a critical level - further issuance seems unlikely.
In related commentary, UBS equity analysts said that they had initially assumed that Fannie Mae would raise about $3 billion in equity in the first half of 2005, to prevent a material shrinkage in its portfolio so they expected that the mortgage portfolio would be reduced to roughly $875 billion at the end of this year. However, they now predict that the portfolio will decline further to about $825 billion at the end of the third quarter as the company decreases its portfolio by approximately $65 billion from its current level.
UBS said margin expansion could offset the effects of a shrinking portfolio as the GSE will no longer have to amortize expenses related to closed cashflow hedges. For instance, UBS noted that at the end of last year, Fannie Mae had $8.5 billion in losses due to closed cashflow hedges on its balance sheet that needed to be amortized over several years. With these losses moved into retained earnings once the company restates its financials, they would no longer have to be expensed as Fannie Mae's current capital level already reflects the impact of this movement. "We now believe that Fannie's interest expense should decline as the company has less hedge expenses to amortize due to the FAS 133 related financial restatement," UBS analysts explained.
Meanwhile, like Fannie, rival Freddie Mac also reported that its retained portfolio decreased by an annualized 11.1% to $647.58 billion, in contrast to a 6.1% drop in December, and an increase of 1.3% for the whole of 2004 (see related story on p.14).
Art Frank, head of mortgage research at Nomura Securities International, said that the reduction in the size of Fannie Mae's and Freddie Mac's retained portfolios - especially in light of Fannie's current capital requirement - would be taking these two regular MBS buyers away from the market, adding that the GSEs were the usual providers of an MBS backup bid. In Fannie's case, it would likely not be a buyer of MBS until the fourth quarter of 2005. Although this could cause spreads to widen slightly, Frank does not expect a dramatic widening or significant supply pressure as a result. The lack of GSE sponsorship would not override current positive factors in the MBS market such as healthy Asian demand and muted fixed-rate supply. Frank added that he does not expect Fannie Mae to shy away from the MBS market for long, as the GSE has not made a long-term commitment to shrinking its portfolio beyond Sept. 30. "I think this is a 2005 phenomenon," said Frank. Although he said that future strategies would still be determined by oversight and regulatory changes relating to both GSEs going forward.
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