What's Ahead for Fannie Mae & Freddie Mac Under Mnuchin?

Shares of Federal National Mortgage AssociationFNMA or Fannie Mae and Federal Home Loan Mortgage CorporationFMCC or Freddie Mac jumped more than 40% last Wednesday. The price movements were triggered by the comments of Steven Mnuchin, Donald Trump's nominee for Treasury Secretary, favoring the privatization of these two companies.

In an interview on Fox Business Network , Mnuchin said, "It makes no sense that these are owned by the government and have been controlled by the government for as long as they have."

He added, "In many cases this displaces private lending in the mortgage markets and we need these entities that will be safe. So let me just be clear- we'll make sure that when they're restructured they're absolutely safe and they don't get taken over again. But we gotta get them out of government control."

Since Nov 30, shares of Fannie gained nearly 15% to close at $3.60 on Dec 6, while Freddie witnessed gain of 13.6%, closing at $3.50.

Fannie, Freddie and Government Ties

Fannie and Freddie are institutions in the U.S. mortgage investment industry with a presence of over 80 years. The firms do not generate mortgage loans but purchase them from lenders and provide credit guarantee. Such loans are then packaged as mortgage-backed securities (MBS) and sold to investors.

In the wake of the subprime mortgage crisis, the firms reached the brink of bankruptcy and were rescued by the Treasury in Sep 2008. The U.S government owns these firms under "conservatorship" of Federal Housing Finance Agency, assisting them financially instead of acquiring full ownership. The U.S. Treasury has warrants that grant it the right to a 79.9% ownership stake. However, the government has not exercised those warrants.

Gradually, with the recovery of the economy and the housing market, these government sponsored enterprises (GSEs) managed to return to profitability in 2012. Initially, Fannie and Freddie were required to distribute 80% of the profits to the Treasury. However, in 2012, such a ruling was amended, requiring 100% distribution of the earnings.

Consequently, this triggered the filing of numerous lawsuits by shareholders against the government and the Treasury opposing such a ruling. Further, such a move restricted the capital generation ability of these firms and currently requires them to reduce capital to zero dollars by 2018.

Notably, the GSEs' major shareholders including Bill Ackman's Pershing Square Capital Management LP and Fairholme Funds, run by Bruce Berkowitz have also filed lawsuits challenging the U.S. government's right to confiscate all profits from Fannie and Freddie.

As of the end of Sep 2016, the GSEs paid around $250 billion in dividends to the Treasury.

Uncertainty Brews

The two mortgage-finance giants currently offer credit guarantee to $6 trillion of U.S. mortgages. However, the future of Fannie and Freddie has always been subject of uncertainty. Policy makers and lawmakers have brought numerous proposals including restructuring, recapitalization, allowing the GSEs to retain some or all profits to increase capital or turning these companies into lender-owned mortgage insurers.

Over the past eight years, the Obama administration has pressed that Congress should pass legislation to reform the housing-finance system. In 2014, apart from winding down Fannie and Freddie, the administration proposed reforms including capital infusion from private sector. However, repeated efforts have failed to materialize.

In Oct 2016, a Congressional Budget Office report stated that without the federal guarantee, "the GSEs would be significantly less profitable, even if they raised private capital, because their costs to issue debt and MBSs would be no lower than those of other very large financial firms."

What Lies Ahead?

Undoubtedly, Mnuchin's recent comments have once again stirred the debate over the future of Fannie and Freddie. Mixed opinions are doing rounds in the market. Mnuchin, who sees the mitigation of the GSE issue as a top priority, promised that he will carry out the separation "reasonably fast."

As the MBSs offered by Fannie and Freddie come with guarantee against default from the U.S. government, global investors finds them lucrative. Also, the government guarantee keeps low mortgage rates in U.S. and facilitates borrowers to finance homes at fixed rates for a prolonged period - as much as 30 years.

Being dominant players in the U.S. housing market, privatization of the GSEs with termination of the government guarantee could result in significant unfavorable outcomes including costlier home financing and higher interest rates.

Also, it may do away with core products like the 30-year fixed-rate loan which has several underlying benefits - smaller monthly mortgage payments, certainty of recurring monthly mortgage payments, safeguards against rising interest rates and the option to refinance at a more lucrative rate when interest rates fall.

However, on the positive side, removal of government guarantee may save taxpayers money in case of any future crisis. As the GSEs capitalizes opportunities in global debt markets through rates much below other private borrowers, the government remains exposed to risks tied with future defaults. The government may no longer bear this risk in case of removal of its control on the GSEs.

Bottom Line

It is still unclear whether removal of the governmental control will make Fannie and Freddie powerful players in the private market. More importantly, there is still a cloud of uncertainty regarding reform in the U.S. housing-finance system under Trump's administration. As of now, Mnuchin's remarks are left for wider interpretations in the market while we wait for further developments.

Stocks worth considering in the finance space include Citizens Financial Group, Inc. CFG and HomeStreet, Inc. HMST .

Shares of Citizens Financial gained over 30% year to date. Over the last 60 days, the Zacks Consensus Estimate increased 3.2% for the current year to $1.91 and 2.3% to $2.17 for 2017.

HomeStreet shares surged more nearly 40% year to date. Over the last 60 days, the Zacks Consensus Estimate increased 17.3% for the current year to $2.91 and 7.1% to $2.88 for 2017.

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CITIZENS FIN GP (CFG): Free Stock Analysis Report

HOMESTREET INC (HMST): Free Stock Analysis Report

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The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

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