Richard X. Bove, Vice President Equity Research at Rafferty Capital Markets, reviews the financials of Fannie Mae and Freddie Mac.
Are Banks Eliminating Fannie Mae & Freddie Mac Holdings? Is It Prudent For Them to Hold This Debt?
Reviewing the Available-for-Sale Portfolios
To do this study the regulatory SNL database for banks was used. That database gathers information from the call reports of individual banks and then aggregates the data to provide the results for the overall holding companies associated with these banks. Specifically what is being assessed is:
- The holdings of government sponsored enterprise (GSE) debt
- Held in the available-for-sale portfolios of
- The 56 banks with assets greater than $25 billion.
What is being discovered is that banks may be pulling away from funding Fannie Mae (FNMA/$2.32/Buy) and Freddie Mac (FMCC/$2.10/Buy). If so this may create meaningful problems for funding the growth in housing.
Moreover, consider the incredible risk that these banks take by holding the debt of two insolvent companies where the government has refused to accept responsibility for the payment of this debt and where the bank regulators have downgraded the quality of the debt. From a pure economic and financial standpoint, one can argue that holding the debt of these companies is imprudent and indicative of careless management. This is not good when lawsuits are being thrown like “Molotov Cocktails” at banks for every step they take.
Key Fannie Mae and Freddie Mac Dates and Data
There are three key dates that need to be considered when reviewing the financials of Fannie Mae and Freddie Mac. They are:
- Q1 2010: when the institutions were ordered to put the loans that they had guaranteed on to their books as part of their consolidated balance sheets.
- Q3 2012: when the companies were ordered to begin sweeping their profits and paying them as a dividends to the United States Treasury.
- Q1 2016: the latest numbers.
Six key numbers in these periods were assets, loans, debt, common equity, total equity, and total equity to assets. These numbers are shown below:
Some points that emerge are as follows:
- The decline in assets which was very pronounced for period 1 (Q1 2010) to period 2 (Q3 2012), slowed appreciably from period 2 to period 3 (Q1 2016).
- A key reason for the easing in the rate of decline is that these two companies are now building their loan guarantee programs once again. From period 2 to period 3, both of these companies have increased their loan guarantees.
- As assets stabilize and loan guarantees grow, the total equity of the two companies moves to zero in absolute terms.
Bank Holdings
The appendix to this report has three tables. Each table culls data from 56 banks with greater than $25 billion in assets operating in the United States:
- The first table provides the amount of government sponsored enterprise (GSE) debt held by the big banks in their available-for-sale (AFS) portfolios. In this table GSE is defined by SNL to mean many government agencies beyond simply Fannie Mae and Freddie Mac.
- The second table lists what SNL has defined as residential mortgage backed securities (RMBS) guaranteed by Fannie Mae and Freddie Mac held by banks in their AFS portfolios.
- The third table is other RMBS held by banks that are guaranteed by government agencies. In this case SNL adds Ginnie Mae to the list of guarantors. It is not a GSE because it is wholly owned by the U.S. government.
Table 1: GSE Debt
The banks in question hold $31.3 billion in GSE debt. Amazingly 47.5% of this amount is held at the Citibank division of Citigroup (C/$46.58/Buy) and Citigroup continues to buy this debt.
The remaining 55 institutions hold $21.2 billion in GSE direct debt and they are selling. In the past year (Q1 2015 to Q1 2016) they have eliminated $5.0 billion in holdings and in the first quarter of this year they sold $0.4 billion. Bank of America (BAC/$14.87/Buy) owns none of this debt; JPMorgan Chase (JPM/$65.32/Buy) has dropped its holdings from $549 million to $35 million; and Wells Fargo (WFC/$50.90/Hold) only holds $19 million.
Table 2: Guaranteed 1-4 Family Loans
There is a dichotomy here. The four biggest banks appear to have dumped $25.1 billion of this debt in the first quarter this year on a linked quarter basis. These sales cause the year-over-year numbers to fall by $4.9 billion.
Conversely, the other 52 banks in the study bought $4.3 billion of these loans in the first quarter and $12.5 billion in the past year to date. These purchases resulted in their total holdings of these RMBS rising by $12.5 billion.
However, the first quarter sales of the big 4 were so large as to cause total holdings by the 56 banks to drop by $20.9 billion in the quarter. This could be a record.
Table 3: Other Guaranteed RMBS
This number is not a good indicator of what is happening with the GSEs because Ginnie Mae is included in the numbers and there is a definite move by banks to buy Ginnies and sell Fannie Mae and Freddie Macs. However, in the first quarter the big 4 dumped $1.6 billion. They eliminated $8.8 billion for the year-to-date. JPMorgan has sharply reduced its holdings, while Bank of America the biggest owner is now the biggest seller.
On a year-to-date basis, the other 52 banks bought $3.9 billion of these instruments. However, in the first quarter, they also turned around and sold $0.3 billion.
Why Is This Happening?
One can point to three reasons as to why these net sales may be taking place:
- Regulatory requirements
- Basic economics
- Statements by presumptive Republican Presidential nominee Donald Trump
Regulatory
The bank regulators have created something called the liquidity coverage ratio (LCR). This requires banks to hold a certain portion of their assets in liquid form. However, all financial instruments are not rated as equally liquid. Cash and Treasuries are at the top of the list. Ginnie Mae securities are also at the top level. These assets are designated as high quality liquid assets (HQLA).
What is no longer on the HQLA top ranked list are securities issued or guaranteed by Fannie Mae and Freddie Mac. Presumably, banks are eliminating these securities and buying Ginnie Maes and other top rated HQLA to meet their LCR requirements. In essence, the bank regulators have created a run on the GSE securities.
Economics
It simply makes no sense for banks to hold the debt and guaranteed instruments of any company that is insolvent. It is against every tenet of the “prudent man” rule. It makes even less sense when it is being acknowledged by the government that the two companies in question will have no equity on December 31, 2017. Holding these securities could be the basis for a class action lawsuit.
Mr. Trump
Mr. Trump has indicated that he would like to treat the debt of the U.S. government as he would a private company. He would like to negotiate a “better deal” with creditors. This was done by a number of Latin American countries in the 1990s and it is being done with Greece at the present time. Cooler heads may have already prevailed with the presumptive GOP nominee concerning Federal debt negotiations.
However, despite the thoroughly grounded view that GSE debt is U.S. government debt, it is not. These two companies are mortgage REITs with insurance operations. These are companies that Mr. Trump understands and has a long history of taking in, and sometimes out of, bankruptcy. It is simply unwise to assume that the debt of these businesses is sacrosanct and that the debt holders in these companies can count on the United States to make good on every penny of every $5 trillion in dollars, pennies.
It is particularly unwise to do this when the government has:
- Arbitrarily eliminated all the rights of the equity holders; and
- Downgraded the debt from a regulatory standpoint.
Conclusion
The banks are pulling away from GSE debt. This is going to create a real problem for housing if they continue. It is going to create a real problem for the banks if they do not continue.
What Should Be Done?
I am constantly asked what I would do with these companies. The answer is relatively simple:
- Step 1: Merge the two entities into one company
- Step 2: Break the new company into two parts
- Step 3: Give the mortgage REIT back to its shareholders as an FDIC insured bank
- Step 4: Separate the insurance company into a new Federal agency
- Set up 12 districts
- Have each district owned by the mortgage originators who want to sell product to the new insurance company
- Provide the full faith and credit of the government behind the insurance company
- Eliminate 1/20th of that guarantee each year
- Have no government guarantee by 2036.
