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GSEs Move Toward Capitalization: What It Could Mean for Investors

Jan 22, 2021 by Liz Brumer
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Government-sponsored entities (GSEs) Fannie Mae (OTCMKTS: FNMA) and Freddie Mac (OTCMKTS: FMCC) play a critical role. Without their services, guarantees, or federal funding, our mortgage and financing systems as we know them today couldn't operate. With this responsibility comes great risk and financial burden, which is why the Treasury and Federal Housing Finance Agency (FHFA) are moving away from the current conservatorship by federal agencies toward capitalization in the private sector. A recent ruling outlining new capital rules for the move into capitalization was made in January 2021. Here's what it means for investors.

How Fannie and Freddie work right now

Right now, Fannie and Freddie work with banks, financial, and lending institutions, buying and packaging groups or pools of mortgages together to create mortgage-backed securities (MBS), then guaranteeing the repayment of these loans and selling these loans to secondary buyers on the secondary mortgage market. Having a government guarantee helps reduce partial risk for buyers in the event of large-scale loan defaults as we experienced in the Great Recession and helps keep the banks and financing institutions that originated the loans liquid so they can continue to create more loans.

In 2008, following the Great Recession, the FHFA took over conservatorship, meaning the burden of keeping these entities liquid so they can maintain the services and guarantees they provide in the marketplace has been largely placed on the federal government, and thus a responsibility of the U.S. taxpayer.

The move into capitalization

Federally backed conservatorship was supposed to be a temporary fix to help "bail out" the industry in a time of need. It was never intended to be a permanent solution. Switching to capitalization, which means the entities would be funded and backed by private capital, is the long-term solution.

According to the new ruling, which has been established with the U.S. Treasury and FHFA, each GSE can issue up to $70 billion of common stock in efforts for capitalization. Investors purchasing shares in the entities will receive variable compensations until the capital reserve end date is met, at which time shareholders will receive quarterly dividend payments equal to the lesser of 10% of the liquidation preference of Treasury’s senior preferred stock, or the incremental increase in the GSE’s net worth in the prior quarter.

Since both entities hold hundreds of billions worth of shares and the new ruling requirements states exit from conservatorship cannot be completed until the GSE has common equity tier 1 capital of at least 3% of its assets, coming out of conservatorship will take time and likely won't be completed for several more years.

What capitalization means for investors

In the meantime, investors may notice higher costs for guaranteed loans, which are issued by Fannie Mae or insured by Freddie Mac, in order for the GSEs to maintain their compensation and dividend return requirements to their investors. Additionally, the new ruling caps each entity's portfolio holdings at $225 billion by the end of 2022, which means if the entities get close to their cap, loan originations and lenders may issue fewer loans. However, considering Fannie Mae's portfolio as of November 2020 was $163 billion and Freddie Mac's was $193 billion, I don't think investors should expect any loan restrictions for quite some time.

The Millionacres bottom line

Increasing capital requirements and establishing more stringent lending guidelines for Fannie- and Freddie-backed loans while shifting the burden for maintaining these loans from the U.S. taxpayer to the private market is a win-win. While higher loan origination rates and fees may seem like a downside, these are fees you were paying already in taxes. Moving into capitalization has many positives, and while it won't be an easy fix, it's a move in the right direction.

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