Policymakers in Washington have recently expressed growing concerns about the (planned) dwindling of capital levels at Fannie Mae and Freddie Mac – the two government-sponsored enterprises (GSEs) that help finance the vast majority of U.S. mortgages. In particular, they worry how the mortgage market may react if the GSEs “draw” additional funds from the Treasury (perhaps after an unprofitable quarter) once their capital levels have dropped to zero.
While we can understand policymakers’ concerns, we at PIMCO – currently one of the largest non-government investors in GSE-issued mortgage-backed securities (MBS) – believe a draw on the Treasury by Fannie or Freddie would not be a market event, nor would it reduce our demand for these securities. Instead, we believe the policy focus should be on what agency MBS investors really care about: making the government guarantee explicit.
Some background: GSEs through the crisis
Fannie and Freddie were put into conservatorship in September 2008 due to concerns about their solvency and the potential consequences on the housing market and broader economy should they fail. For several years, the GSEs drew funds from the Treasury in order to continue providing liquidity to investors – and, by extension, access to mortgage credit for homebuyers – before becoming profitable again in 2012.
At that point, the Federal Housing Finance Authority (FHFA), the GSEs’ conservator, agreed to remit all of Fannie and Freddie’s profits ($276 billion to date) to the Treasury department above a specified capital threshold. That threshold was $3 billion in 2013 and will decline to zero by the end of 2017 under the legal agreement governing the conservatorship.
Concerns about ‘zero capital’ may be missing the point
So why, despite policymakers’ concerns, can we say with some confidence that a draw on the Treasury by Fannie or Freddie would have no impact on our investment behavior or our interest in agency MBS on behalf of our clients?
For one thing, Fannie and Freddie have a collective credit line at the Treasury of $258 billion that they can draw on at any time. To put that amount in context, during and right after the financial crisis – the housing market’s most significant downturn in modern history – the two entities drew a total of $188 billion from the Treasury, far less than the funds currently available to them.
For another, Fannie and Freddie continually run stress tests, and the FHFA has found1 that if the housing market were to decline by 25% from current levels, the two agencies would still have $71 billion–$148 billion of Treasury capital left to draw from.
Finally, the market has been aware of the planned reductions in capital since August 2012 – for more than five years. If market participants were concerned about additional foreseeable draws, which are likely, we think agency MBS would be trading at far different levels – lower prices and higher risk spreads – than they currently do.
Additionally, we think the debate about capital levels may be missing the point, given that even a $3 billion capital cushion would likely be insufficient in the event of a market downturn. With that said, if officials are concerned about an adverse market reaction to a Treasury draw, a reminder to investors about the GSEs’ available Treasury credit line could provide comfort.
Shifting the policy focus
We think the policy focus should be on the dimension investors care most about: codifying an explicit government guarantee. We believe that any viable housing finance reform must include an explicit guarantee of both legacy and future GSE mortgage-backed securities in order to avoid significant disruption to the secondary mortgage market, and by extension to the housing market as a whole.
We also believe that any changes to the GSEs need to be done in the context of comprehensive housing finance reform, which includes reforms to the private mortgage market aimed to make it a functioning source of mortgage credit once again.
Without such changes, we believe the government may continue to be the only real player in the mortgage market.
For more of our views on housing finance and the U.S. mortgage markets, see “Housing Finance Reform: First Things First.”
Libby Cantrill is PIMCO’s head of public policy and a regular contributor to the PIMCO Blog. Michael Cudzil is a portfolio manager on the liability-driven investment team, Daniel Hyman is co-head of the agency mortgage portfolio management team and Kent Smith is a portfolio manager on the mortgage credit team.