Market Fall-Out From GSE Buyout Announcements

Yesterday, both Freddie and Fannie announced their schedules for buying seriously delinquent loans out of their guaranteed securities. The buyouts have been anticipated by the marketplace since the economic consequences of implementing FAS 166/167 as of this month became clear last fall. Freddie’s plan takes substantially all out this month; Fannies takes an unspecified amount out over a period of a few months starting next month. (Again, the accounting treatment for loan purchases is not the same as that for loans held on the GSEs balance sheet subsequent to FAS 166/167 consolidation. The GSE is required, under its guarantee, to pay out par to investors: prior to consolidation that bought out loan was booked at fair value, for an instant 40-60 point hit to capital; the newly consolidated loans came on balance sheet at par and are subject to standard methods of measuring allowances for loan losses, in effect spreading the loss over time and conserving capital – something taxpayers should prefer.) Given the significant impact bulk buyouts would have on the investment performance of securities with high concentrations of delinquencies (especially 30-year 6s, 6.5s and 7s issued in 2006-8) market has been watching for any sign the buyouts were underway. It has been scrutinizing in debt issuance (which would fund buyouts) and prepayment reports, but it clearly did not expect a straightforward announcement and most were taken by surprise (add that New York, where most broker/dealer MBS analysts are located, was finally getting a real share of the snowpocalypse). When I posted commentary on the announcements yesterday afternoon only one firm, off the path of yesterday’s storm, had gotten out comments and prepayment projections based on Freddie’s announcement. By morning, however, several thoughtful examinations of both enterprises announcements had arrived in the email. So thoughtful, I wanted to update my comments yesterday with their observations. The announcements are a relief. Analysts at Credit Suisse led by Mahesh Swaminathan say the positive development for the market “removes a substantial amount of prepayment uncertainty and injects potential reinvestment demand of around $60B in March and as much as $115B over the next few months.” However, they also noted that the GSEs own a substantial amount of MBS in their portfolios, which could limit pay outs to other investors by 10-15%. Vipul Jain at Bank of America/Merrill Lynch notes that the buyouts can actually cause a decline in net issuance, because the paydowns are driven by credit events not refinancings, and hence don’t result in creation of new securities. New MBS supply can only follow if the delinquent loans are foreclosed and underlying properties liquidated or the delinquent loans cure and are resecuritized. I suggested yesterday that the market should react more positively to Freddie’s approach. Laurie Goodman at Amherst Securities spells out why:  “Freddie’s buyout program was implemented in a way to be minimally disruptive to the market. The February settlement date has passed, and the Feb/March roll is no longer trading.” Investors who hold mortgages this month will suffer an unavoidable one time loss, but going forward, pools settling Freddie trades will be much cleaner. By contrast, Goodman notes Fannies announcement “will make trading more difficult” because it is not clear which securities will be bought out in which order.” She suggests that Fannie offer a clear program – will buyouts proceed by degree of delinquency, coupon, issue year, or some other measurable? Goodman gets a fine point too – the difference between the programs is governed by a clear operational difference between the two enterprises. Freddie can buy directly out of a pool, but Fannie has to ask the servicer to do so. “Thus, the additional month delay is to allow servicers to gear up for this, and the few month timeframe is meant to allow for servicer capacity constraints and other operational issues.” Given those constraints, she says Fannie is implementing buyouts as quickly as possible. Portfolio implications are different for the two enterprises as well: Goodman expects Freddie’s purchases to bring it close to its $810 billion cap, but prepayments and liquidations through the year will naturally increase freeboard. This is important – me talking now – to allow Freddie to step in with a backstop bid for MBS after the Fed departs. Fannie, on the other hand, will, in Goodman’s words, be “far more constrained.” Fannie announced that it had $127 billion of loans four or more months delinquent, but it only has about $37 billion of clearance currently under its 2010 limit ($810 billion, same as Freddie). In other words, they need the portfolio to run off to allow them to complete anticipated buyouts. Goodman’s math suggests they’ll squeak through, but may not be back as quickly as Freddie to buyout future 120+ delinquencies or may have to sell securities to accommodate additional buyouts. Analysts all have different views on how the two will fund their purchases. Swaminathan at CS estimates 70% of buyouts will be funded through short term debt issuance and the remainder through Treasury preferred capital, but taxpayer dollars don’t figure in other discussions. Goodman expects both to fund through debentures. FTN Financial agency analyst Jim Vogel thinks Freddie has prefunded most of its February buydowns, but Fannie will have to ramp up issuance. RBS agency analysts worked through current liquidity position at Freddie, recent issuance, likely runoff and liquidation cash flow to estimate Freddie would need to issue just $600 million more this month to cover buyout-related funding needs. Differences between the two plans were reflected in price action in yesterday’s trading. Vipul Jain, publishing after the market close noted price spreads between Freddie and Fannie 30-years rallied significantly (in market parlance Gold/Fannie swaps, for example better by 17 ticks in 6.5s in Freddie’s favor). Color from Market News International‘s widely followed FI Bullet service indicated that Fannies came under pressure after the Freddie announcement, with some decent selling of higher coupons by real and fast money and some fleeing into the safety of Ginnies. NOTE: Linda Lowell writes a regular column, called Kitchen Sink, for HousingWire magazine. Editor’s note: Linda Lowell is a 20-year-plus veteran of MBS and ABS research at a handful of Wall Street firms. She is currently principal of OffStreet Research LLC.