Outlook 2010: Fannie Mae, Freddie Mac unlikely to see major changes in 2010: market observers

By Kenneth Lim

Boston, Dec. 31 - The U.S. government will probably make only minor changes to Fannie Mae and Freddie Mac in the short term because of the sheer mass of the market, pundits said.

"We believe that at this point there is a low probability of major change in the GSE business model," wrote Cantor Fitzgerald chief rates strategist George Goncalves in a note. "The GSEs are playing a crucial role in the nascent recovery of the housing market. Instead of sweeping changes, we see minor tweaks developing in 2010 with some starting before the end of [2009]."

The government, which assumed conservatorship of the two mortgage agencies in September 2008, is expected to lay out its plans for the agencies by March 2010. For agency investors, some of the main questions are whether the government will nationalize the two largest issuers of agency debt, whether a good bank/bad bank structure will emerge, or whether the current status quo will be maintained.

To nationalize or not

With Fannie Mae and Freddie Mac stuck with immense portfolios of debt, investors are split on whether the government will simply take on their obligations, in effect nationalizing the two agencies.

Goncalves does not believe that nationalization will occur.

"A main issue among foreign buyers is that to this day the GSEs still do not have an explicit guarantee (but instead deep credit lines to the Treasury)," he wrote. "We believe that the explicit move is a non-starter as the U.S. government cannot afford to bring the GSEs on the balance sheet."

But the fact that the expected GSE announcement in 2010 is timed to coincide with the president's budget has been cited as support that nationalization is in the works, according to Barclays Capital analysts Rajiv Setia, James Ma, Nicholas Strand, Saravanakumar Velayudham and Derek Chen in a note.

The Barclays team believes that nationalization is inevitable because the government will likely have to maintain conservatorship for an "indefinite" amount of time given the expected losses at Fannie Mae and Freddie Mac. But such a move will not happen in February, the team said.

As Goncalves suggested, to take on both agencies' debt at this time will be extremely burdensome for the Treasury, suggesting an addition of about $2 trillion in debt on the government's balance sheet, the Barclays team wrote.

Politically, nationalization could also fuel criticisms of fiscal irresponsibility and could complicate the ability of the agencies to retain talent, the analysts added.

"This rationale does not change the endgame of putting the GSEs into receivership eventually, wiping out the existing preferred and equity holders," the analysts wrote. "Senior debt holders and [mortgage-backed security] holders should have no worries even in this scenario, given the pledge made by the government with the [preferred stock purchase agreements].

"However, in our view, the denouement will occur when Congress has had time to formulate a vision for housing finance. We suspect the timeline for this could be a decade away."

Good bank, bad bank

The government could also combine the GSEs, then split them into a private enterprise that holds the "good" assets and a federally controlled entity that holds the "bad" assets.

Timing is again the key to such a solution, the Barclays analysts wrote.

Trying to restructure the GSEs in this way will be difficult in the near term because doing so will trigger receivership at Fannie Mae and Freddie Mac. The process is also complicated by the difficulty of defining "bad" assets, and the likely confusion in secondary markets over how existing MBSs will be split.

But with origination standards tightened this year, the agencies' balance sheet should be stronger in five to 10 years, which would make a good bank/bad bank solution more feasible at that time, the analysts said.

"Therefore, we believe the government would be able to sell a 'good bank' to private investors at a higher price in several years instead of right away," the analysts wrote.

Minor tweaks

Market sources said they expect only small changes in the meantime, until more significant changes at Fannie Mae and Freddie Mac can be implemented.

One agency trader said the size of the market and its role in the economy makes it difficult for the government to make any big changes without causing a large amount of disruption.

"The biggest scenario is if Fannie Mae and Freddie Mac go away, but the debt will continue to trade," the trader said. "They'll still have to set up a separate entity for the existing debt."

Goncalves said the government could take some measures in the short term to continue supporting Fannie Mae and Freddie Mac.

The first is to increase the $200 billion credit line currently available for each agency. Indeed, on Dec. 24, the Treasury removed the limit on the lifeline, allowing the amount that each agency can draw to be determined by their losses and how much is required to keep them at positive net worth.

The government also eased the requirement that the agencies reduce their portfolios beginning in 2010. The reduction targets are now based on the caps of $900 billion for each agency instead of the agencies' actual portfolios.

But Goncalves also said the Treasury could lower the 10% dividend rate that the agencies have to pay on Treasury-bought preferreds as well - to 5%, in line with banks that received aid during the financial crisis - and lower the risk weighting on GSE debt to zero.

Michael Graf, head of agency trading at Barclays, said even the end of the conservatorship could be a few years away.

"They could set a sunset date for the conservatorship, but that date could be five years out," he said. "There's no magic recipe there. There are simpler things the administration could propose, but truly redefining the system will take a long time. I could see things go sideways next year. You're not going to change it overnight."

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