The crisis of confidence surrounding Fannie Mae (FNM) and Freddie Mac (FRE) culminated on Sept. 7 when the regulator of both government-sponsored entities (GSEs), the Federal Housing Finance Agency (FHFA), placed them under a regulatory conservatorship. We believe this was a preemptive move, intended to remove a major uncertainty contributing to market turmoil and to ensure the GSEs can fulfill their public policy role of providing liquidity to the U.S. mortgage market. Although the GSEs were in capital compliance and had access to funding, they faced further financial and capital stress in the midst of the historically weak U.S. housing market.
The government's main concerns about Fannie and Freddie appear to have been their capital strength and the market's reaction to heightened uncertainty about how and when the U.S. Treasury Dept. would exercise its newly enacted liquidity-backstop plan. The GSEs were evidently placed under conservatorship to reduce systemic risk to the broader global financial markets. The aim also was apparently to restore the GSEs' capacity to fulfill their role of providing liquidity to the U.S. mortgage market through Treasury's new liquidity facilities and the new senior preferred stock purchase agreement it made with each GSE. Standard & Poor's Ratings Services understands that the Treasury actions were taken with three key objectives: market stability, market availability, and taxpayer protection.
While we view this action as generally positive, the conservatorship raises immediate questions for the operations of Fannie Mae and Freddie Mac and for the broader financial-institutions sector. Overall, however, we believe that Treasury, FHFA, and banking regulators will work together to bolster the financial sector and capital markets. Clearly, senior and subordinated debtholders are protected under the conservatorship, while holders of preferred and common stock may suffer disproportionately. Here are our views regarding some of those questions.
What was the impact on the credit ratings of Fannie Mae and Freddie Mac?
We affirmed our long-term AAA and short-term A-1+ senior unsecured debt ratings on Fannie Mae and Freddie Mac. The outlook is stable. At the same time, we lowered our risk-to-the-government stand-alone issuer credit ratings on Fannie Mae and Freddie Mac to R (regulatory supervision) from A- and withdrew the ratings. We have also revised the CreditWatch listing of the BBB+ subordinated debt ratings on these entities to positive from negative. In addition, we lowered the preferred stock ratings to C from BBB- and removed the ratings from CreditWatch with negative implications. The subordinated debt and preferred stock ratings were originally placed on CreditWatch on Aug. 26, 2008.
What does a C rating on the preferred stock mean?
The C rating reflects the cessation of dividend payments on these securities. Fannie Mae and Freddie Mac have issued only noncumulative perpetual preferred stock, in which unpaid dividends do not accumulate. This is the only type of preferred stock that is eligible for regulatory capital purposes. Under the terms of the Senior Preferred Purchase Agreement, there is a covenant prohibiting the payment of dividends on existing preferred stock (other than the newly issued senior preferred stock) and common stock. It is currently difficult to assess the status of any resumption of dividend payments.
What is the form of Treasury liquidity and equity support to the GSEs that led to Standard & Poor's affirmation of the senior unsecured debt ratings?
Over and above general statements of support by Treasury that confirm the GSEs' viability and their pivotal role in the U.S. mortgage markets, the department also announced two forms of liquidity support for the GSEs and a senior preferred stock purchase agreement to provide equity support for them. It was these explicit actions of support for GSE debt that led to our affirmation of the senior debt ratings and the placement of subordinated debt on CreditWatch Positive. The new Treasury actions are:
•A senior preferred stock purchase agreement pursuant to which Treasury will purchase senior preferred stock from Fannie Mae and Freddie Mac on an as-needed basis; the program size is up to $100 billion of issuance per GSE. These preferred securities will rank senior to all existing preferred stock. Commencing Mar. 31, 2010, the GSEs will pay Treasury quarterly a periodic commitment fee in the form of either cash or a payment in kind. This program does not have an expiration date. Clearly, this outsize amount should put to rest market concerns regarding potential financial support the GSEs may need in the future.
•A secured credit facility for Fannie Mae, Freddie Mac, and the Federal Home Loan Bank (FHLB) System that expires on Dec. 31, 2009. The only eligible collateral is agency mortgage-backed securities (MBS) for Fannie Mae and Freddie Mac, and advances for the FHLB System. The secured credit facility has no dollar limit. The loan maturities under the program are to be in the range of one week to one month and are priced at Libor + 50 basis points. Because the GSEs currently fund at a much lower level than the pricing on this facility, it is clearly a symbolic liquidity-backstop measure, and we believe the move was intended to increase the market's confidence in the GSEs should extraordinary financing be needed.
•Commitment to open-market purchase of newly issued agency MBS to broaden the liquidity of these securities and of mortgage funding for current and prospective home buyers. Treasury may begin their MBS purchases later this month and additional purchases will be on an as-needed basis. This commitment expires on Dec. 31, 2009. GSE agency MBS issuance through July was $270 billion for Freddie Mac and $383 billion for Fannie Mae. The monthly volumes of new MBS issuance year-to-date as of July have been $36 billion to $69 billion for Fannie Mae and $22 billion to $47 billion for Freddie Mac. Although this volume seems small, we expect higher volumes next year as the GSEs face growth constraints on their retained portfolios. This means that new MBS issuance will be the key source of mortgage financing next year.
What are the critical covenants in the Senior Preferred Stock Purchase Agreement that most affect the GSEs?
In our view, the Senior Preferred Stock Agreement is the main tool Treasury is using to support outstanding GSE debt. The sale of senior preferred stock to Treasury is expected to occur if the FHFA determines that a GSE's liabilities have exceeded its assets under generally accepted accounting principles (GAAP). This would eliminate any mandatory triggering of receivership. There are significant growth and payment restrictions placed on Fannie Mae and Freddie Mac, which include:
•Limit in debt increases to 110% of its debt as of June 30, 2008
•GSE retained mortgage and MBS portfolio cannot exceed $850 billion as of Dec. 31, 2009, and this portfolio will decline 10% per year until it reaches $250 billion
•No capital stock repurchase transactions and no payment of dividends on common and existing preferred stock
•No issuance of capital stock
What is a conservatorship?
A conservatorship is the legal process by which the regulator gains full control and oversight of a company to manage its business in a safe and sound manner and to preserve asset and franchise valuations. Under a conservatorship, all of the powers of the company's directors, officers, and shareholders are transferred to the designated conservator. The length of time Fannie Mae and Freddie Mac will operate as a conservatorship is as yet undefined. We expect it to continue through the end of 2009 at a minimum.
Who will manage the GSEs?
David Moffett was appointed the CEO of Freddie Mac to replace Dick Syron, and Herb Allison was appointed the CEO of Fannie Mae to replace Dan Mudd. Moffett was with the Carlyle Group and prior to that was the CFO of U.S. Bancorp (USB). Allison was a senior executive of TIAF-CREF and former vice-chairman of Merrill Lynch (MER).
Does the GSEs' business change under the conservatorship?
The public policy role of providing liquidity to the broader mortgage markets will not change as Fannie Mae and Freddie Mac operate under conservatorship. They will continue to follow GAAP accounting Securities & Exchange Commission disclosure rules. However, under the covenants of the senior preferred stock purchase agreements, the GSEs face restrictions on the growth of their indebtedness and mortgage assets held in the retained portfolio.
The restriction on balance-sheet growth is another intended outcome of the conservatorship. Regulators plan to reduce the size of Fannie Mae and Freddie Mac to limit the occurrence of future systemic risk concerns.
How does the GSE conservatorship affect the broader financial institutions' sector?
In our view, the GSE conservatorship should ease the immediate market concerns regarding Fannie Mae's and Freddie Mac's capacity to execute their core role of providing liquidity to the U.S. mortgage markets. We also expect it to bolster the liquidity and pricing of agency MBS. Financial institutions that rely on the GSEs as a source of secondary market liquidity for their mortgage originations, especially fixed-rate mortgages, should view this as "business as usual" in their business with the GSEs. If it improves the market valuations of agency debt, it will benefit the financial institutions that invest in these securities.
What's next for the GSEs?
Treasury called the appointment of the conservator and the liquidity and equity support a "time out" for Fannie Mae and Freddie Mac. In our view, the structural flaws and ambiguity of the inherent conflict of the GSEs, serving a public policy role while meeting shareholder value demands, now is in the hands of the next Congress and the soon-to-be-elected President of the U.S. and his Treasury administration. The political risks that have always been a factor in our ratings on the GSEs continue. These actions taken by FHFA and Treasury may have eliminated some of the uncertainty surrounding the GSEs, but they have also created new doubts. The critical question of how and in what legal form the GSEs will exit the conservatorship is left unanswered. In short, the ambiguity of the GSEs' charter will remain until the next Administration addresses Fannie and Freddie's fate.