‘Twas late in the day before Christmas and few – apparently – were expecting a big announcement from Treasury concerning Fannie and Freddie. And it was big. To make sure they got our attention, the Treasury un-characteristically issued the press release header in capital letters (cyber etiquette dictates that all caps is YELLING). The Treasury announced (1) it was allowing two programs to terminate as scheduled (at inception in 2008) at the end of this year, the Treasury $200bn GSE MBS purchase program and the unused short term credit facility established for the enterprises and the Federal Home Loan Banks; (2) it was changing the calculation of the cap on its funding commitments to Fannie and Freddie, (3) it was giving the two housing finance enterprises greater flexibility in meeting their portfolio reduction requirements; (4) it was putting off for a year, to December 31, 2010, setting the periodic commitment fee the GSEs will owe on unused financing; and (5) 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. Two of these changes are critical for MBS markets: removing the $200bn caps on capital support for each enterprise and giving the GSEs “wriggle room” in their portfolios. Both are discussed below. Once Again, Mainstream Press Misleads I learned of the Treasury’s move from analysts and the Treasury’s press release, so I was taken aback (but never surprised) by the shallow, misleading and sensationalized reports it garnered in the media. Under headlines like “U.S. Move to Cover Fannie, Freddie Losses Stirs Controversy” (WSJ) and “U.S. promises unlimited financial assistance to Fannie Mae, Freddie Mac” (Washington Post) and “Treasury removes cap for Fannie and Freddie aid,” (Associated Press), writers did their best to make the move sound controversial. J.W. Elphinstone at The Associated Press said, “the government has handed its ATM card to beleaguered mortgage giants” and Louise Story at the New York Times construed it as an offering of significant new support “no matter how badly they perform in the next few years,” an offer made at the same time the biggest banks are repaying their bailout funds. And writers did their best to fan fears about the GSE’s future performance. For example, Elphinstone tracked down long time thrift and banking consultant Bert Ely on the holiday for this quote: “The companies are nowhere close to using the $400bn they had before, so why do this now? … It’s possible we may see some horrendous numbers for the fourth quarter and, thus 2009, and Treasury wants to calm the markets. So, let me interrupt my short “winterlude” to restore the context, aided by commentary from several analysts whose work I admire for its thoroughness and its respect for facts before politics. Now that I am “off the street” and like all American householders watching my own assets deflate, I would much rather hear from these folks than the media about what is happening in housing and housing finance. They Raised the Cap’s Intelligence Let’s start with “uncapping” Treasury support under the Preferred Stock Purchase Agreements (PSPAs) authorized by the Housing and Economic Recovery Act (HERA) of 2008. Under the new calculation the maximum amount either enterprise may draw is the greater of $200 billion, or $200 billion plus the cumulative amount of deficiency amounts covered by Treasury preferred purchases as of December 31, 2012, less any surplus at December 31, 2012. Deficiencies are negative net worth measured in any quarter; these require the enterprise to sell preferred stock to the Treasury to maintain net worth at zero. Surpluses are positive net worth. Please notice that the new calculation provides for the possibility that the enterprises will not continuously run in the red. The mechanics are a little vague – suppose an enterprise draws $210bn through Q111 but emerges with a $20bn surplus at December 31, 2012. Does the Treasury claim the surplus at that time? Nonetheless, including surpluses in the cap formula is an important and appropriate adjustment. Freddie Mac did draw a total of $51bn over the first three quarters the agreements were in place (Q3 and Q4 of 2008, Q109), but it finished Q2 and Q3 with positive net worth ($8.2bn and $10.2bn respectively). It had no need to draw on Treasury for funding. More fundamentally, the game has radically changed since Congress (spurred on by a strong scapegoating and retribution-mongering spirit) and the Paulson Treasury wrote the rules for GSE support. Private lenders (including the biggest ones paying back their TARP money, Ms. Story) are making few residential mortgages for their own books, and there is NO investor appetite for privately securitized mortgages. And furthermore, between FAS 166/167 and proposed requirements that securitizers retain significant risk, prospects are not bright for a renewal of private securitization. Like it or not, at present home sales and refinancings are overwhelmingly supported by FHA/Ginnie Mae, Fannie and Freddie. Equally significant, and completely unforeseen by the Congress and Administration that authored HERA, Fannie and Freddie are bearing a disproportionate share of the burden for mortgage modifications. Although there is much that can be written on this issue, Credit Suisse mortgage analysts Mahesh Swaminathan and Qumber Hassan put it succinctly in a report published last November on the expected impact of HAMP modifications on prepayments: The GSEs have a much higher share of HAMP trial mods compared with their share of overall delinquencies for the mortgage universe. No PSA constraints and relaxed NPV requirements for mods make it easier for servicers to initiate trial mods on GSE-backed loans. (Translation: PSAs are the pooling and servicing agreements that govern, among other things, what modifications of securitized private mortgages. Although mass reviews of PSAs and the creation of a legal safe harbor should give servicers sufficient latitude to modify much larger numbers of loans, the possibility of law suit remains as the interests of different classes of investors in a deal are often not aligned and decision-making responsibility appears divided between servicers and trustees.) Also, thanks to high unemployment and the precipitous decline in home values, the delinquency and foreclosure crisis has spread to loans underwritten to traditional credit standards – the bulk of Fannie and Freddie’s books of business. Official estimates from Treasury and the Congressional Budget Office indicate the caps are sufficient, but some analysts have been arguing for more headroom. In a December 11, 2009 piece, Barclays Capital analysts led by Rajiv Setia published a lengthy examination of the GSE’s current condition and the future of government involvement in US housing finance. Noting that serious delinquencies continue to rise, they tested the original caps under a base and stress-case scenario. In both cases they found that $200bn was more than sufficient for Freddie. However, given that Fannie’s credit book is 50% larger, they questioned the wisdom of providing the same level of support to both enterprises. Under the stress scenario, “the $200bn backstop may prove too close for comfort, especially in a double-dip recession.” Swaminathan at Credit Suisse, in a note written over Christmas weekend, similarly saw the risk as small: “The only way GSEs would need to tap more than the $400bn capital line previously provided is if there is a housing double dip that causes losses on GSE credit books to exceed 8%.” Right Timing Barclays’ December report called on Treasury to raise the cap for Fannie before year end to counter this small risk. Which brings us to the question of timing. This is something Ely, as a frequently quoted, oft-testifying critic of and expert on the enterprises, should have known. It’s not about unforeseen losses this quarter. It’s in the law: the Treasury’s authorization in HERA to alter the terms, conditions and amounts under any agreements (such as the PSPAs) to purchase Fannie or Freddie obligations expires December 31, 2009. After that date, new authorization would be required from Congress. Reporters were able to dig up members of Congress who cried foul that the Treasury department used its authority to alter the PSPAs without consulting them. But really – if Congress had intended to micromanage GSE backstop funding, Treasury would have had different authorities and different timetables from the get-go. More to the point, given the central role Fannie and Freddie now play in sustaining home sales and refinancings as well as in preventing liquidations through foreclosure (the force weighing on housing markets around the country), the Treasury had no choice but to lift the caps. Too much is at stake, for taxpaying homeowners, to leave outstanding even a small “tail risk” that one of the enterprises would penetrate the cap. We’ve all seen how politics – even the agendas of a small minority – can stall lawmaking by the majority. Read the law (HERA): if a deficiency goes unfunded, the deficient enterprise goes into receivership. Though many – including those who presumably know better (so they may do it on purpose) – use the terms receivership and conservatorship interchangeably, they are vastly different. Under conservatorship, the GSE regulator FHFA oversees the normal, business as usual operations of Fannie and Freddie. Under receivership the two businesses are wound down. Certainly the enterprises’ die-hard foes might relish seeing them in receivership, but it does not take much imagination to foresee any number of unpleasant consequences that would follow fairly quickly on a halt to government-sponsored guaranteed securitization of residential mortgages. You think all you have to do is take away FHA and GSE loans and the banks will step up? You think the housing market can’t get any worse? Confidence Builder The Treasury’s announcement was greeted by analysts, who interact continuously with investors in GSE MBS and debt, as a strong positive for investors. Jim Vogel at FTN Financial heard, “The spirit of the Paulson Treasury is carried forward by Geithner’s in the idea ‘whatever it takes’ to convince investors the US stands behind the MBS and debt issued by Fannie and Freddie.” According to Margaret Kerins at RBS, the action should allow the GSEs “to issue debt with ease, especially 3-years and under.” Credit Suisse’s Swaminathan saw it as “mixed for agency debt because positive sentiment from expanded government support is offset by the potential for increased supply.” More background – the context missing from press reports – is needed to understand why investor confidence is an issue. MBS investors and the analysts who seek to advise them have been struggling with two concerns for months: the potential for a sharp widening in MBS spreads when the Fed reaches the expected end of its MBS purchase program around the end of Q1 2010 and the impact on prepayments as HAMP modifications and other credit events trigger an escalation in the pace at which the GSEs buy loans out of pass-through securities. Moreover, bringing guaranteed securities back on the GSEs balance sheets with adoption of FAS 167 on January 1 changes GSE incentives to buy loans out and has raised investor fears prepayments will accelerate sharply. (I ran through these concerns for HousingWire readers a revamping of HAMP to include principal reduction. Indeed, equity analysts at Keefe, Bruyette & Woods anticipated this could be an outcome of removing the funding cap. In their note, Bose George and Jade J. Rahmani note the GSEs are already at the “forefront” of HAMP efforts, but given the limited effectiveness of the program they believe “the government is likely to push for an enhanced version of HAMP which allows for some form of principal reduction.” That is, removing the cap makes room for principal reductions which necessarily result in immediate losses on modified loans.