The expanded role of the GSEs may be a double-edged sword for the financial stability of the U.S. economy, market participants said last week.
Discussion in the market was sparked after a provocative report from Standard & Poor's suggested that the GSEs pose a greater financial risk to the U.S. government's AAA' rating than brokers.
"The GSEs are massively levered mortgage entities, and the country is trying to fix a problem of too much mortgage leverage by adding more mortgage leverage. But this time, mortgage leverage is in the hands of the GSEs," a market source said.
Between both Fannie Mae and Freddie Mac, the GSEs have exposure to roughly $5.5 trillion in mortgages, including $4 trillion in the guarantee portfolio and $1.5 trillion in the investment portfolio. However, the amount of capital between both GSEs is less than $100 billion, said Ajay Rajadhyaksha, head of U.S. fixed- income strategy at Barclays Capital.
The GSEs benefit from the belief that the agencies' obligations are backed by the U.S. government. "Support for the GSEs is at a historic high right now and it is critical," said Vincent Arscott, senior director in the financial institutions group at Fitch Ratings. He noted that the rating agency has historically always had a high support rating of 1,' which means that if one of the agencies were to get into trouble, the government would support them on a senior unsecured basis. "If you really want to characterize a need for the GSEs, this is the time and this is the place," he said.
More Mortgages, More Problems
Over the past few months, both Fannie Mae and Freddie Mac's capital surplus ratio was reduced to 20% from 30% by the Office of Federal Housing Enterprise Oversight. At the same time, the conforming loan limit was increased to 125% of the median home price to a maximum of $729,750, which further expands the GSEs' range of coverage.
These changes place a significant amount of additional pressure on the agencies' balance sheets. "The GSEs are facing these higher demands for liquidity at a time when their own core mortgage performance is weaker, and there is a higher degree of uncertainty regarding the broader market conditions," S&P said in a report last week.
Given the size of their obligations, if the agencies were to face trouble, the debt of the U.S. government would increase by roughly $5 trillion dollars, and would most likely widen out spreads on U.S. Treasurys, the market source said.
Indeed, the total mortgage portfolio for Freddie Mac has increased at an annualized rate of 8.4% year to date and rose 12% in February, the latest available date, while the single-family delinquency rate for all loans was 71 basis points in January, up from 65 basis points in December. Fannie Mae's book of business grew at a compound annualized rate of 19.5% in February, while the single-family serious delinquency rate rose eight basis points in January to 106 basis points.
"The losses on the guarantee portfolio have begun to mount, and unless the housing market stabilizes, those losses could continue to rise for the next few quarters," Rajadhyaksha said.
For 1Q08, the fair value of net assets is likely to be marked down $10 billion to $12 billion for Fannie Mae and $5 billion to $8 billion for Freddie Mac, according to a Barclays report. The bank suggested the agencies would need to raise an additional $10 billion each, though it is more likely that they will raise no more than $3 billion each, consistent with the reduction in their capital surcharge, Barclays said.
Also boosting capital, Freddie Mac unveiled an agreement with Wells Fargo Home Mortgage, Chase, Washington Mutual and CitiMortgage, last Thursday. This is aimed at making more funds available for larger home loan purchases. Freddie said it expects to finance between $10 to $15 billion in jumbo mortgages in 2008 (see whispers, page 6).
The Worst Is Yet To Come
Given their expanded role, incremental credit risk is going to be added on the balance sheet. "What we think largely is that their credit risk is a reflection of the U.S. housing market, which unfortunately right now is showing no signs of easing," Fitch's Arscott said. He added that Freddie Mac had indicated that the market is only one-third of the way there. "And that is their conservative assumption," Arscott said.
But despite raising the conforming loan limit in high-cost states, which means higher loan balances and higher severity of losses, from a pricing standpoint the GSEs have been fairly aggressive in trying to price that risk and in raising fees. They have also tightened underwriting as well as adding surcharges to certain products, Arscott said.
However, while the majority of prime borrowers are not defaulting, the GSEs have a lot more leverage than capital, which would exacerbate even a small liquidity issue within the company. "If the GSEs were a bank, they would have been shut down, like, five times. You would open them just to close them down again to make your point," a source said.
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