So farewell then, 10 per cent Fannie and Freddie senior pref dividends.
You were very complicated.
The US Treasury announced on Friday that it will instead use all the profits generated by Fannie Mae and Freddie Mac in order to pay off their taxpayer bailouts. It’s supposed to replace a 10 per cent ceiling on the dividend paid on Treasury-held preferred shares in both GSEs.
The adjustment also speeds up Fannie and Freddie’s wind-down of their investment portfolios from 10 per cent to 15 per cent annually, though it’s not clear if the wind-down would have reached this pace anyway.
That might not sound like very much but, crucially for the GSEs’ credit risk, the latest amendment will waive the dividend when the GSEs make net losses. It also achieves the effect of making certain that the GSEs’ fate will be uncertain for some time to come.
Right, so, the Treasury is selling this as a plan to “make sure that every dollar of earnings each firm generates is used to benefit taxpayers”.
Well, it certainly comes at a funny time for serious reform of the US housing market, which is also of some interest to taxpayers.
Now, a combined total of $190bn in preferred stock means (meant) $19bn of annual dividend payments for the two agencies together.
Fannie and Freddie earned $5.1bn and $3bn in net income respectively last quarter, which (unusually) allowed them to pay dividends to the US Treasury without drawing funds from the US Treasury, in that famous little circular arrangement. This could be part of a housing turnaround; Fannie’s numbers were boosted by a reversal in provisions for mortgage credit losses, for example, which had caused it to haemorrhage billions over the years.
But while Fannie said it “does not expect total loss reserves to increase above $76.9 billion in the foreseeable future”, nor has it expected “to generate net income or comprehensive income in excess of our annual dividend obligation to Treasury over the long term.”
So the recent profits were really a no man’s land for the agencies’ ultimate fate — whether they could be viable as private companies, or whether the government should end the charade of conservatorship, tackle the looming cash-flow problem, and take them over.
Witness the budding trade in GSE junior preferred shares for instance, betting on the tail event of the GSEs returning to sufficient, independently-managed profit to reinstate payments on them. Not just the senior. “Some of the smartest funds in the world are very long Freddie prefs in a very big way on a notional basis, and have been for some time,” as Distressed Debt Investing put it.
Well, the bet had blown up spectacularly on Friday – which to be fair was the “lottery ticket” nature of the trade.
But it shows where Friday’s dividend switch has taken the debate — towards longer-term conservatorship, shading on government direction of the GSEs, without much light on the desired end-state.
Some thoughts from Barclays’ rates team:
With the change in support, we see virtually no chance of the post-YE12 capital supports being exhausted over a multi-decade period. This is primarily because of the high quality of the post-conservatorship guarantee book, coupled with our view that provisioning for legacy credit losses is essentially complete (also in line with the Q2 results).
In our view, this puts to rest any worries about GSE credit risk even in intermediate/longer maturities. Thus, we expect the agency-Treasury spread curve to flatten sharply and can envision 10s trading at T+15-20bp. By accelerating the pace of portfolio shrinkage to 15%, this should also boost the positive supply technical for agency debt, further buoying valuation.
…the GSEs are now, more than ever, dependent on the government. By removing virtually all concerns about standalone credit and appropriating all profits, the government is signaling what most market participants already know: that FNM/FRE are essentially off-balance-sheet government entities. The question remains whether this move will be enough to change perceptions of investors (typically overseas) that have previously differentiated between Treasury/GNMA and FNM/FRE securities.
We think that over time, the answer to this question is an unambiguous yes. Any signal that the Fed/OCC is considering reducing FNM/FRE risk weights as a result of this dividend change would increase investor appetite for agency debt/MBS; however, this would also further entrench FNM/FRE securitization, complicating any transition to another housing finance model.
Treasury to wind down GSEs faster, only to be replaced with (insert solution here) – Housing Wire