The Treasury's ninth-hour announcements on Dec. 24 changed the outlook for the government-sponsored enterprises in 2010.
For the next year, the Federal Reserve-supported purchase program will continue business as usual. The changes mean that the securitization market will not have to immediately imagine a market with less of a GSE presence.
It comes as welcome news for MBS investors, who, at the close of last year, anticipated a potentially sharp widening in MBS spreads when the Fed stopped its MBS purchase program by the end of 1Q10.
Specifically, the U.S. Treasury Department amended the terms of the Preferred Stock Purchase Agreements (PSPA) with Fannie Mae and Freddie Mac.
The most significant change was to increase the amount of capital available from the U.S. Treasury to $289 billion plus any quarterly deficit in 2010, 2011 or 2012 less any surplus as of December 31, 2012.
The Treasury also announced it was making technical adjustments to definitions of assets and liabilities in the Preferred Stock Purchase Agreements (PSPAs) in light of accounting changes driven by Financial Accounting Standards (FAS) 166/167.
In addition, the amendment delays the imposition of a commitment fee until January 1, 2011 and changes the calculation that limits the size of the GSEs' mortgage portfolio.
This is the second amendment of this agreement between the U.S. Treasury and the GSEs.
"These amendments provide further evidence of the strong support for the GSEs by the U.S. Treasury," said Brian Harris, senior vice president at Moody's Investors Service. "Fannie Mae's and Freddie Mac's senior debt ('Aaa') and subordinated debt ('Aa2') already incorporated our view that the U.S. government will continue to support these entities resulting in minimal risk for bondholders."
Across the board, it is largely understood that both Fannie Mae and Freddie Mac are needed to help stabilize the housing market. To be certain, the private lending institutions are making few residential mortgages for their own books, and there has been no real investor appetite for privately securitized mortgages.
This is why the changes from the Treasury are seen as critical for the MBS markets. For starters, the raised portfolio caps mean that the GSEs can now collectively increase mortgage holdings this year by about $100 to $120 billion. After 2010, the portfolio caps become 90% of the previous year's cap (not 90% of the previous year's portfolio size). This cap will continue to shrink until the entities are capped at a combined $500 billion.
This is in sharp contrast to prior requirements which would have required that the GSEs reduce their portfolios by 10% per year based on their size at the end of 2009. JPMorgan Securities analysts said that this would have implied a reduction of about $150 billion on a combined portfolio of approximately $1.5 trillion in 2010.
"With a portfolio size of $1.51 trillion as of the end of November (the latest available data), the GSEs won't be forced to sell MBS until 2012, all things equal, when the portfolio cap reaches $1.46 trillion," estimated Barclays Capital analysts. "We project that by 2022 the caps will bottom out at the $500 billion level."
Treasury on Capital Commitment
On the capital commitment side, the Treasury announced it would allow the funding commitment to "increase as necessary to accommodate any cumulative reduction in net worth over the next three years."
Additionally, the definition of "mortgage assets" counted against the caps now explicitly states that it disregards changes made by FAS 166/167. For the GSEs it means that MBS guarantee-related assets and liabilities, which will be consolidated onto their balance sheets, will not count toward the portfolio caps.
"In other words, for the next several years, [the] Treasury will stand behind the GSEs to ensure that, despite any potential negative earnings during the period, they maintain a positive net worth," Barclays analysts explained. "We believe the main reason behind this was to reassure investors of the government's commitment to the GSEs and by extension, the creditworthiness of GSE debt and MBS. The fact that the open commitment is finite in term (i.e. three years) helps reduce the possibility that GSE liabilities would have to be counted against the U.S. debt ceiling."
Industry sources explain the timing of the late-hour shifts in policy down to the fact that the Treasury's ability to make these changes without Congress's involvement would have expired at the end of 2009, making it harder to administer these changes at a later date.
Room to Buy Could Push Prepayments
According to industry analysts, the previous portfolio caps may have constrained the amount of buyouts that Fannie Mae and Freddie Mac could conduct, as the GSEs would have needed to sell MBS to make room for delinquent loans. The less restrictive portfolio caps could marginally increase the overall buyout pace for 2010.
As it stands now, the GSEs have rung in 2010 with a combined $200 to $300 billion more room to add MBS, either through delinquency buyouts or outright purchases. The agencies will no longer be forced to sell MBS when they buy out a delinquent loan as they would have under the old rules for 2010.
"The Treasury announcement gives us some headroom to add assets to the portfolio," said Michael Cosgrove, a spokesman at Freddie Mac. Cosgrove reiterated that even before the announcement Freddie Mac remained focused on its role in providing liquidity to the market.
GSE Incentives
Bringing guaranteed securities back on the GSEs balance sheets with the adoption of FAS 167 on Jan. 1 also changes GSE incentives to buy loans out and has raised investor fears that prepayments will accelerate sharply.
"The major reason that the GSEs have not bought out the large number of delinquent loans in MBS pools is a capital constraint; when a nonperforming loan is bought out at par, it is immediately written down on the balance sheet to about 40% of face value, which is approximately the market bid side price for pools of seriously delinquent nonperforming loans," Deutsche Bank Securities analysts said.
The capital for this loss must be obtained from the Treasury Department, which is costly. Analysts said that the GSEs must typically pay a 10% dividend to the Treasury on such preferred stock.
"For the GSEs, buying out a 6.5% loan at par, then borrowing 60% of the face amount and paying 10% on the loan is not, of course, a profitable business model," JPMorgan analysts said. "So, for the most part, the GSEs have chosen to leave such seriously delinquent loans in MBS pools and continue to pay investors the coupon month after month."
But those incentives have changed. Since the start of the year all GSE loans, delinquent and performing, are already on the balance sheet at par, so buying loans out of pools will have no impact on the GSEs' balance sheets anymore. The delinquent loans will already be on Fannie and Freddie's balance sheets, and there is no more write-down once they are bought out.
The GSEs will still have to obtain the cash to buyout loans. But according to Barclays estimates, the GSEs could easily issue $100 to $200 billion in discount notes over a period of a month or two, thereby funding the buyout purchases.
That would have an effect on the Constant Prepayment Rate (CPR), which represents the proportion of underlying mortgages that would be paid off in a year at the current pace.
For instance, Barclays analysts took into account the unlikely event that Freddie Mac bought out all the seriously delinquent 30-year 2007-vintage 6.5 coupon loans, it would result in a one-month speed of 77 CPR - so about 77% of the mortgages would be expected to be paid off within a year. Spreading the buyout over three months would end up with 37 CPR.
However, that doesn't mean the GSEs will indeed buy out all the delinquent loans in January.
"While it's advantageous for them to buy out loans to reduce the principal and interest that they're advancing (estimated to be about $15 billion per year), they may weigh this against the potential market disruptions that a spike in prepayments could cause," Barclays analysts said.
It's also likely that competition between the GSEs could cause buyouts to be spread out. If one institution performs a large-scale concentrated buyout program, it could adversely affect the pricing of their securities and hurt their market share of new issuance.
The GSEs typically behave very economically with regard to their portfolios, according to JPMorgan analysts. Additionally, even since being placed into conservatorship, the institutions have continued to act in this manner.
"Given where agency funding levels are relative to agency MBS, it is far from economical for the GSEs to grow their portfolios," analysts said. "Mortgages have traded at a negative spread relative to agency funding for all of 2009 and still remain at about -35 basis points. The GSEs are unlikely to significantly expand their portfolios until mortgage spreads widen significantly."
However, they said that even if spreads remain tight, it is unlikely that the GSEs remain in run-off mode, as these agencies have a more important role as a policy tool. The net selling pressure would also probably be the only pressure on the basis just as the Fed purchases are expiring.
JPMorgan analysts said they did not expect the GSEs to considerably increase their buyout activity.
"There are still a number of other operational funding, and hedging impediments that remain intact," JPMorgan analysts said. "For example, as the GSEs remain very large owners of agency MBS, a buyout 'spike' would likely have very negative valuation repercussions on their retained portfolio. Funding is equally a concern, as flooding the market with debt may not be in the GSEs' best interests either."
How the GSEs play out their extra headroom in future MBS purchases is still up in the air, but what is at least clear is that the Treasury is willing to take the steps to assure investors that it is standing behind MBS and GSE-issued debt.
The action should at the very least allow the GSEs "to issue debt with ease, especially three-years and under," said Margaret Kerins, managing director of agency debt strategy at RBS Securities. For now, the GSE's will continue to be the primary bearers of the mortgage credit risk in the new issue market.
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