Fannie and Freddie privatization: What does it mean for MBS?

In February, we explored the likelihood that Fannie Mae and Freddie Mac would be privatized following President Trump’s call to release the two government-sponsored entities (GSEs) from government control. Since then, Trump has met with several major banks that are vying for a role in a potential initial public offering (IPO) of Fannie and Freddie.

Considering these developments, we revisit the likelihood of full or partial privatization. But more importantly, we discuss how the U.S. might handle government guarantees on agency securities, highlighting the importance of those guarantees and the implications for investors in agency mortgage-backed securities (MBS).

A full IPO presents challenges

For background, when the U.S. government bailed out Fannie Mae and Freddie Mac in 2008 amid the housing market collapse, it effectively took a stake in the two companies by way of a senior preferred stock purchase agreement (SPSPA).

The SPSPA ensures that any retained increase in the value of the GSEs equates to an increase in the value of the U.S. taxpayer’s stake in the companies. In 2019 and 2021, amendments were made to the SPSPA that allowed the GSEs to begin retaining capital – an important step toward potentially going private.

However, the agreement also stipulated that as Fannie and Freddie’s capital reserves increase, so do the amounts owed to the U.S. Treasury to reimburse U.S. taxpayers.

The current estimated value of the Treasury’s position is close to $340 billion, an amount that would either need to be forgiven by the Treasury (highly unlikely considering this is essentially money owed to U.S. taxpayers) or would need to be paid off by way of an IPO. At their current valuations, the GSEs would need to raise more than 10 times the capital raised in the largest IPO ever (Saudi Aramco in 2019 at $29 billion).

An IPO of that size seems very unlikely, and therefore we would consider full privatization an unrealistic proposition. Partial privatization over time seems a more viable scenario, where a reasonably sized IPO can be undertaken at first, with subsequent equity issues taking place over time thereafter.

The most important issue: Government guarantees on agency MBS

While equity investors may be interested in the capital implications of privatization, investors in agency MBS should be more focused on the government guarantee, or backstop, on agency securities. In our view, the issue of the government guarantee has far greater implications for fixed income investors than whether, when, or how Fannie and Freddie are privatized.

The administration is on the record as saying that, should Fannie and Freddie be privatized, the guarantee would remain in place. While the current guarantee is an implicit one, it is important to note that the market interprets it as if it were an explicit guarantee. We do not believe privatization would cause any disruption to this situation, as the backing has always been implicit, even before the U.S. government’s conservatorship of the GSEs.

A gradual process of privatization

Given the capital requirement challenge and questions around the Treasury’s senior preferred position, it seems probable that the GSEs would gradually privatize and shrink their footprint over time. There are several ways to accomplish this, including lowering conforming loan limits, tightening minimum credit requirements, or raising the fee they charge for the guarantee.

Furthermore, there is arguably no public-policy reason for the GSEs to conduct cash-out refinancings, or to provide loans for investment properties and second homes. So, there are several avenues that can be pursued to reduce the extent of the GSEs’ future loan issuance (and their accompanying government guarantees). We think a combination of these options is the most likely path.

Conclusion

To reiterate, we believe that if the administration moves forward with privatization, it is expected to reinforce the government guarantee on agency securities. It is highly unlikely that the administration would take the GSEs private with no government backing, as the guarantee is a vital component of the marketability of agency MBS to investors and helps to promote both lower mortgage rates and the healthy functioning of the mortgage and housing markets.

From an investor perspective, if the GSEs’ footprint shrinks via some of the avenues outlined above, it could result in less net supply and be constructive for agency MBS spreads over time.

The proposed IPO of Fannie and Freddie is a fluid situation that may continue to unfold over several months, with the inevitable headlines and rumors circulating. While we are monitoring the developments, we maintain our view that privatization would have minimal impact on securitized markets, and we remain constructive on the outlook for agency MBS.

IMPORTANT INFORMATION

Derivatives can be more volatile and sensitive to economic or market changes than other investments, which could result in losses exceeding the original investment and magnified by leverage.

Fixed income securities are subject to interest rate, inflation, credit and default risk. The bond market is volatile. As interest rates rise, bond prices usually fall, and vice versa. The return of principal is not guaranteed, and prices may decline if an issuer fails to make timely payments or its credit strength weakens.

Initial Public Offerings (IPOs) are highly speculative investments and may be subject to lower liquidity and greater volatility. Special risks associated with IPOs include limited operating history, unseasoned trading, high turnover and non-repeatable performance.

Mortgage-backed security (MBS): A security which is secured (or ‘backed’) by a collection of mortgages. Investors receive periodic payments derived from the underlying mortgages, similar to the coupon on bonds. Mortgage-backed securities may be more sensitive to interest rate changes. They are subject to ‘extension risk’, where borrowers extend the duration of their mortgages as interest rates rise, and ‘prepayment risk’, where borrowers pay off their mortgages earlier as interest rates fall. These risks may reduce returns.

Securitized products, such as mortgage-backed securities, are more sensitive to interest rate changes, have extension and prepayment risk, and are subject to more credit, valuation and liquidity risk than other fixed-income securities.