Last week, United States Housing Starts data was released showing the housing sector finished 2017 trending upwards and the beginning of 2018 on strong footing. Housing starts surged in January to the second highest rate of expansion since 2006.
Additionally, housing permits for new construction printed strong results as well, confirming the underlying confidence there is for housing demand in the United States. However, the completion rate for new homes continues the lack of supply for new homes to an already depleted market.
With all things pointing to a positive narrative in Housing came A not so positive caveat; Fannie Mae and Freddie Mac’s fourth quarter and full-year results. Turns out that President Trump’s recent Tax Reform Bill wasn’t great for everyone. Both mortgage finance providers reported a comprehensive loss of $10 billion and thus, will require additional funding from the United States Treasury. The losses were a consequence of the corporate tax rate being lowered, and tax credits held on balance sheets of corporations with much less. In this case the $10 billion provision.
This triggered me to dig up old notes taken on Fannie and Freddie. What can be done to remove the inherent credit risk these two GSE’s pose to the United States’ economy? Well, the Mortgage Banker’s Association came with a plan that would keep the taxpayers on the hook to guarantee all MBS products, which fell flat on policymakers ears. On the other hand investment firm Moelis & Co.LLC has an idea on how to recapitalize Fannie and Freddie so the two housing enterprises can exit conservatorship, with limited government involvement of the GSE’s, which is certainly I think worth looking into by those in Washington.
Before examining the plans already proposed to reform the ailing mortgage companies, some thoughts on the original businesses of Fannie and Freddie with the sole thought of preserving the 30-year prepayable fixed rate mortgage being the critical foundation of the housing market. Put another way, the 30-year, prepayable, fixed rate mortgage is the bedrock of the United States Housing Market. This is because the 30-year, prepayable, fixed rate mortgage has a variety of attributes that make it an affordable and borrower-friendly financing option for the average American. For instance,
The 30-year amortization term allows for smaller monthly mortgage payments and it removes the refinancing risk inherent in balloon payment loans. The Fixed interest rate provides certainty of recurring monthly mortgage payments while protecting against a rise in interest rates. Lastly, the prepayment option without penalty benefits the borrower in times when interest rates decline, and borrowers have the ability to refinance at a more attractive rate.
That bedrock was strengthened by the original charter of Fannie Mae and then Freddie Mac by the United States Congress in 1938 and 1970 respectivley, to support the liquidity, stability, and affordability in the secondary mortgage market after the Great Depression in 1929.
However, before the Great Depression, mortgage availability was limited, with 5-to-10 years terms, with floating interest rates, and banks reporting 50% loan-to-value ratios. Mortgages were primarily originated and retained by local thrifts, commercial banks, and insurance companies. Banks would lend at floating interest rates for a short-term to match the structure of their deposit funding sources. The supply of mortgage credit was limited, and pricing of said credit varied widely across the United States, thus to obtain a mortgage required a large initial down payment.
Then comes the Crash of 1929 and the subsequent Great Depression, which lasted until 1939. The Unemployment rate reached 25%. Housing prices were halved. Of all the outstanding mortgages throughout the country at the time 25% were in default and 10% of the homes were in foreclosure.Homeowners were unable to satisfy their principal payments and were unable to refinance their short-term mortgages. The banking system was near collapse and was unable and unwilling to provide a meaningful amount of credit to the housing market. Thus, the mortgage market was paralyzed and required significant government involvement to recover. The government’s involvement in the housing market has been ever present.
The government’s response to the Great Depression was to undertake a series of mortgage-related initiatives that culminated with the creation of Fannie Mae. Those being:
1933: Created Home Owners’ Loan Corp: That issued government-backed bonds to fund the purchase of defaulted mortgages from financial institutions. Home Owners’s Loan Corp converted short-term, variable rate mortgages into long-term, fixed-rate mortgages.
1934: Enacted National Housing Act, which established the Federal Housing Administration. That provided credit insurance on long-term, fixed-rate mortgages made by approved lenders.
1938: Created Fannie Mae, as a government agency. Fannie Mae would purchase FHA-insured loans to provide liquidity for mortgage lenders, as noted above.
Well, in the next thirty years Fannie Mae accomplished all three. Here are some highlights:
1948: Fannie was allowed to purchase loans insured by the Veterans Adminitration. As a thank you for their sacrifice to our country Fannie Mae provided liquidity to long-term, low-down-payment mortgages that were issued to veterans returning from WWII.
1954: Fannie was converted into a “public-private, mixed-ownership” company.
1968: Fannie was converted into a for-profit, shareholder-owned enterprise. Fannie was allowed to buy non-government backed mortgages.
1970: Freddie Mac was created to securitize mortgages issues by the savings and loans institutions.
1971: Freddie issued the first conventional loan MBS
1989: Freddie converted into a for-profit, shareholder-owned enterprise.
The business of both Fannie and Freddie in the mortgage market was to convert long-term, illiquid mortgages into highly-liquid mortgage securities (MBS), also to provide insurance on the credit risk on the underlying mortgages of the MBS, and lastly to facilitate the sale of MBS to the global capital markets. By doing so, and creating a highly liquid investment security that is insured against credit risk, the GSEs allow borrowers to access the global capital markets.
In the case of Fannie and Freddie’s original business, that being to guarantee the timely payment of interest and principal on a portfolio of mortgage-backed securities. This being a cash and insurance-float-generative business model where payment is received up front in exchange for the promise to pay potential losses incurred in the future. The business model was leveraged to positive long-term trends in the housing markets. The economies of scale that GSEs are able to achieve allowed them to be the lost-cost provider for the American borrower. The summary, the guarantee business model was asset-light, with a high-return-on-equity. One that did not rely on funding from the capital markets nor did it require the use of derivative instruments to hedge their credit risk.
However, jumping ahead to the 1990s Freddie and Fannie’s business model change drastically. They began to buy more of MBS instruments and issuing more debt. They became the largest financial institution by the number of assets but in turn, were highly leveraged institutions that needed access to large amounts of capital. Effectively becoming a government-backed hedge funds.Moreover, they started to buy subprime mortgages, ALT-A mortgages and meanwhile, guaranteeing all of it which ultimately lead the pair to be taken over in the wake of the Global Financial Crisis.
What a few activist investors have eluded to in the past, namely Bill Akman, of Pershing Square Capital Management, was that what is needed is to wind down the old business model of Fannie and Freddie, that being Fixed Income Arbitrage, and returning the two GSE’s to their original business of being a guarantor of interest and principal payments on middle class mortgages for creditworthy borrowers.
Below are the current plans laid out in comparison tables that have been purposed by the aforementioned Moelis & Co LLC, along with other contributors, entitled Safety and Soundness Blueprint. Along with the ICBA(Independent Community Bankers of America) Principles, and the MBA (Mortgage Bankers Association) Plan.
To Wit: all plans relied upon the deferred taxes held on Fannie and Freddie Balance sheet as a pro for the taxpayers if the old business model could be wound down and out of receivership.
Source: Moelis & Company