Thursday morning was an eventful time for the government-sponsored enterprises.
At the same time that Freddie Mac announced that it returned to profitability in the fourth quarter after previously reporting a loss for the first time in four years, Mel Watt, the director of the Federal Housing Finance Agency, gave a sweeping speech on the state of the GSEs.
Notable among the many topics that Watt discussed was the long-term viability of GSE conservatorship, the GSEs lack of capital, Congress’ rebuke of Watt’s efforts to raise the pay of GSEs’ CEOs, and even the lack of housing finance reform talk on the presidential campaign trail.
Watt’s speech, given Thursday morning at the Bipartisan Policy Center, touched on the FHFA’s current role as conservator of the GSEs, but also identified several risks to the long-term health of the country’s housing finance system because of the unsettled nature of Fannie Mae and Freddie Mac.
One big issue that Watt identified is the GSEs lack of capital.
“The most serious risk and the one that has the most potential for escalating in the future is the Enterprises’ lack of capital,” Watt said, according to his prepared remarks.
Under the Preferred Stock Purchase Agreements that went into effect when the government took the GSEs into conservatorship, Fannie and Freddie send dividends to the Department of the Treasury each quarter that they are profitable.
Freddie Mac, for example, will send $1.7 billion to the Treasury, based on its fourth quarter 2015 results.
But under the PSPAs, the GSEs are prohibited from rebuilding capital and each of the GSEs capital base is required to be reduced, with their capital reserves scheduled to be drawn down to $0 in 2018.
And that has Watt concerned.
Watt identified a number of “non-credit” factors that could cause Fannie or Freddie to suffer a quarterly loss, as Freddie Mac did in the third quarter, which may require Fannie or Freddie to take another draw from the Treasury, including:
1. Interest rate volatility
2. Accounting treatment of derivatives, which are used to hedge risk but can also produce significant earnings volatility (which is what happened with Freddie Mac in Q3)
3. Reduced income from the Enterprises’ declining retained portfolios
4. The increasing volume of credit risk transfer transactions, which transfer both the risk of future credit losses as well as current revenues away from the Enterprises to the private sector
Watt also said that a “disruption” in the housing market or a “period of economic distress” could also lead to credit-related losses and trigger a draw from the Treasury.
Watt said that while it’s “impossible” to predict what the ramifications would be of another draw, there are several distinct possibilities.
“First, and most importantly, future draws that chip away at the backing available by the Treasury Department under the PSPAs could undermine confidence in the housing finance market,” Watt said.
“The remaining funds available under the PSPAs provide the market with assurance that the Enterprises can meet their guarantee obligations to investors in mortgage-backed securities even while they are in conservatorship and don’t have the ability to build capital,” Watt continued.
“In effect, the Treasury Department’s financial commitment to each Enterprise under the PSPAs is a source of capital that supports mortgage market liquidity,” Watt said.
“However, under the terms of the PSPAs, these funds can only go down and cannot be replenished,” he continued. “Future draws would reduce the overall backing available to the Enterprises, and a significant reduction could cause investors to view this backing as insufficient. It’s unclear where investors would draw that line, but certainly before these funds were drawn down in full.”
Watt said that investor confidence is “critical” to the health of the housing market, and future draws may seriously dent that confidence and therefore impact borrowers ability to obtain credit.
“Investor confidence is critical if we are to have, as we do today, a well-functioning and highly liquid housing finance market that makes it possible for families to lock in interest rates, obtain 30-year, fixed-rate mortgages, and prepay a mortgage if they want to refinance or need to move,” Watt said. “If investor confidence in Enterprise securities went down and liquidity declined as a result, this could have real ramifications on the availability and cost of credit for borrowers.”