With the GSEs solely supporting most of the MBS market, Fannie Mae's and Freddie Mac's future takes on added significance in saving the mortgage market from a total collapse.
However, despite the apparent reliance on these institutions, the virtue of GSE reform has still been highly debated in the market.
In a recent Wells Fargo report, analysts said that these agencies will probably eventually be restructured as government-owned mortgage insurers without their arbitrage portfolio. The analysts added that the likelihood of these companies liquidating is actually more than the market currently thinks - 30% to 50%.
"Valuing these institutions as they are today and using the worst case scenario, the g-fee that the GSEs charge comes up short and not appropriately priced," Glenn Schultz, a managing director at Wells Fargo, said. "The GSEs are using government-subsidized debt to fund their arbitrage portfolios that, in turn, subsidized their below-market guarantee fees. This may have contributed to the increased levels of risk in the GSEs' arbitrage portfolios."
The firm's scenario analysis looks at the impact of removing the implicit government support on the conforming mortgage market, comprising GSE guaranteed loans.Analysts believe that Fannie and Freddie MBS buyers without this guarantee might have market value losses resulting from haircuts of between $356 billion and $495 billion. The ultimate principal losses that are based on projected guarantee fee shortfalls might be approximately 1.58% of the notional amount outstanding or equivalent to $71 billion.
This is why analysts said that the current agency MBS market is caught between a rock and a hard place. On one end, the government must inject considerable capital to stabilize the GSEs that Wells Fargo analysts said might total $190 billion.
While on the other, the agency MBS investors, without government sponsorship of the market, might lose up to $495 billion in market value because of credit haircuts. The firm's scenario analysis also projects that a market after these enterprises have been liquidated based on a self-insuring pool structure might result in a 15- to 20-basis-point mortgage rate rise as well as reduce upfront proceeds or net servicing and residual valuations to issuers by as much as three to five points.
Without the GSEs in the picture, Schultz said that there will be changes to the competitive landscape in the mortgage market. "The GSEs act as a conduit; they don't originate or service loans. Instead, they create liquidity for the mortgage market by re-underwriting and wrapping these securities," he said. "We have calculated the GSE advance rates in the absence of the GSEs based upon a self-insuring structure with upfront overcollateralization and excess spread. Assuming 1.2% cumulative losses with a five times coverage ratio to achieve triple-A, then you could come up with the overcollateralization haircut of 6%. From this, one can derive the value of a self-insuring structure with the government pool policy to backstop losses. A structure of this nature minimizes government liability while, at the same time, provides government support to maintain the desired depth of investor participation in the mortgage market."
Analysts also asked whether a self-insuring structure could be utilized to re-securitize the existing agency MBS market. The short answer, according to analysts, is no. They think that it is close to impossible, in the case of legacy agency MBS pools, to deploy a re-securitization program utilizing excess interest and overcollateralization. This is because the overcollateralization structure represents a haircut to the notional balance of the MBS pool, which is to be borne by the investor, translating into a market value loss. The degree of the required overcollateralization as well as subsequent loss will depend on market pessimism. To be sure, the overcollateralization is recovered on the back end net of realized credit losses. Additionally, the question also becomes who is to pay the pool policy insurance premium on seasoned mortgage pools. Instead of securitization, the legacy MBS pools of the GSEs would actually, according to Wells Fargo analysts, run off in their projected scenario at the same time as the mortgage market.
Wells Fargo analysts concluded that recapitalizing the GSEs as government-owned mortgage insurers against catastrophic loss without their arbitrage portfolios while allowing the current obligations to run off is the most probable outcome. Irrespective ofwhat the outcome is, whether it is liquidation orwhether these agencies become merely mortgage insurers, rational pricing will probably result in a modest rise in borrower rates to homeowners and lower advance rates to mortgage lenders.
Despite believing that there's a higher chance that these institutions will liquidate, Schultz thinks that eventually these institutions "will in some form or fashion be merged together and will essentially have their book run off. I don't think politically speaking they could start over, but they have to figure out a way to honor their debt obligations and pool guarantees. We have to figure out how the government can provide sponsorship to the conforming mortgage market while limiting its liabilities."
MBA's Proposition
The Mortgage Bankers Association (MBA) last week released a new paper defining its proposed framework for a refined government role in the secondary mortgage market. The suggested role was designed to ensure the mortgage market's liquidity without presenting unnecessary risks to the taxpayer.
The MBA also suggested a new line of MBS with each security having two components. The first is a security-level, federal government-guaranteed "wrap" (GG) analogous to that of a GNMA security. This would, in turn, be backed by private, loan-level guarantees from privately owned, government-chartered and regulated mortgage credit guarantor entities or MCGEs. The GG theoretically would be similar to the Ginnie Mae model and would guarantee the timely interest and principal payments to bondholders, would explicitly carry the full faith and credit of the U.S. government and would be supported by a federal insurance fund, boosted by risk-based fees charged for the securities at issuance and on an ongoing basis. The MCGEs will rely on their own capital bases and risk retention from originators, issuers and other secondary market entities such as mortgage insurers. By having these programs, the credit risk of the underlying mortgage would be taken out from the securities issues, while the interest rate risk would stay with the security investor, according to the MBA.
Jay Brinkmann, chief economist at the MBA, said that the MCGEs will be well capitalized. However, unlike having just two main agencies, having several of these institutions will allow them to get away from the concept of them being too big or small enough to fail.
The MBA suggested a security-level credit guarantee backstop that relies on security-level risk-based premiums that are paid into a federal insurance fund as well as loan-level guarantees offered by a small number of MCGEs. The MBA proposed that the government backstop should be explicit and be focused on the credit risk and market liquidity or mortgage-related products, and not on interest rate risk. According to the MBA, the loan-level MCGE guarantee should be such that it would absorb all mortgage-related credit losses and the federal insurance fund called upon only on occasions of extreme distress.
"I wouldn't dwell too much on the number," he said. "We think the regulator would decide the initial number and, based upon circumstances, the number of MCGEs could increase." Brinkmann added that the regulator of these institutions would probably be similar to how the Office of the Comptroller of the Currency and the Office of Thrift Supervision function. "These entities would do away with Congressional charters and some of the problems associated with that. They would basically be credit guarantors for securities that would then be put into the market with characteristics that would make these securities liquid; investors essentially will focus only on interest rate and prepayment risks."
He said that clearly defined Federal support will likely determine whether there is going to be sufficient market liquidity. "We are trying to focus on the fundamental needs of investors versus what borrowers and originators want or need," Brinkmann said.
Nothing Clear Cut
Bert Ely, president of Ely & Co., said that there's no current consensus on or clear-cut answers as to what the future of Fannie and Freddie would be. The fate of these institutions is set to be addressed in the 2011 budget. However, Ely said that "it's unclear to me what they are going to propose; none of the options on the table look attractive on principle. It's because the wrong question is being asked."
The "threshold question," according to Ely, is: how should the financing of owner-occupied homes in this country be funded? He said that until this question is answered, he doesn't think that the fate of the GSEs could be decided.
Meanwhile, he stated that there is an option that has been barely started in the country that could provide an alternative to the role that the GSEs play - covered bonds. "The sector has well-established techniques that are much more efficient and safer," Ely said.
On the issue of GSEs liquidating their portfolios and keeping these institutions as mortgage guarantors, Ely said, "As insurers, they don't need those huge portfolios that essentially served as a tax regulatory arbitrage for their shareholders." He added that the extent of their mortgage credit risk business and the amount of the MBS that they own is a tougher question. "If they don't assume that risk, who does? Will the private sector do so? They don't have the maturity mismatch in their balance sheet, but there will always be the issue of the mismatch as long as you have shorter-term debt funding longer-term paper," Ely said.
There is also the investor appetite for Fannie Mae and Freddie Mac paper. "The real question is how are these trading over Treasurys?" Ely said. "With the huge amount of outstanding, the question comes back to finding an investor. Although foreign investors are still really turned off by Fannie and Freddie paper, a lot depends on the extent to which the government stands behind them even considering the credit losses for the taxpayers and the state of the U.S. economy. If you're a medium-term investor, you might get a lot more conservative and look at the nature of the backing and how trustworthy it is."
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