The analysis of the changes in the GSEs' delinquent loan buyout policies focused on their impact on prepayment speeds and coupon swaps. An underlying notion was that the implementation of FAS 166 and 167 by Fannie Mae and Freddie Mac, which took place effective at the beginning of 2010, paved the way for the announcement; since the loans are now carried on their books at fair value, buyouts no longer have any affect on the GSEs' income statements.

However, adopting the new accounting rules required the consolidation of massive amounts of MBS trust assets and liabilities onto the GSEs' balance sheets. The consolidation will in turn have a significant impact on their financial statements, and arguably was a significant factor in the Treasury's Dec. 24 announcement of unlimited support for the GSEs. Along with the prospect of continued operating losses, these changes will eventually impact the upcoming debates on housing, the federal budget and the future of the GSEs.

According to the firms' Securities and Exchange Commission filings, adopting the new accounting standards forced the bulk of MBS trusts outstanding - roughly $2.4 trillion for Fannie and $1.5 trillion for Freddie - to be consolidated onto their financial statements. Clearly, the balance sheets of the two entities will grow to enormous proportions. Fannie alone will have total assets of roughly $3.3 trillion, up more than threefold from $890 billion as of the third quarter.

However, the consolidations will also have a major impact on their income statements. As I understand it, the reason that the delinquent loan buyouts will not have a P&L effect is because writedowns will already be taken into account as part of the consolidation; in essence, non-performing loans are booked at fair value once they are put on balance sheet. The losses resulting from these actions will be above and beyond the $77.4 billion allocated for GSE support in the 2011 budget statement over the next two years. In fact, Freddie Mac has already indicated that the accounting changes will reduce their net equity by $11.7 billion in 1Q10. As with operating losses, the resulting negative equity will need to be offset by the Treasury under the Conservatorship.

The prospect for continued massive capital infusions explains why the Treasury decided to eliminate the ceilings for support of the GSEs, which they announced on Christmas Eve. Until then, support from the Treasury was limited to $200 billion each for Fannie and Freddie. The presence of a ceiling on support risked disruptions in the markets for agency debentures and MBS; if it appeared that Treasury support was running out, investors might begin to question the government's commitment to supporting the GSEs.

Nonetheless, I expect a political fight to ensue once total support to the GSEs exceeds roughly $200 billion. Such a debate may in turn trigger a reassessment by investors of the government's appetite for GSE support. This may be the point when investors begin to balk at the deliberate ambiguity of the Treasury's "implied guarantee" of Freddie and Fannie. Ultimately, the Treasury's pledge of unlimited GSE support has only postponed an inevitable reassessment of the GSEs by investors, despite the muted market and media response to the Christmas Eve announcement.

In addition, the massive expansion of the GSEs' balance sheets will impede efforts to restructure the two enterprises. Despite calls to "abolish" Fannie and Freddie, there are no clear precedents for winding down entities with combined liabilities roughly as large as the federal budget. Fallout from the consolidation will ultimately destroy the illusion that the GSEs' fate can be addressed without a massive and costly effort.

Bill Berliner is a mortgage and capital markets consultant based in Southern California. His Web site is www.berlinerconsulting.net.

(c) 2009 Asset Securitization Report and SourceMedia, Inc. All Rights Reserved.

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