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U.S. Government Cost To Resolve And Relaunch Fannie Mae And Freddie Mac Could Approach $700 Billion

Publication date: 04-Nov-2010 09:42:29 EDT

As Standard & Poor's Ratings Services sees it, the problems in the U.S. housing market are far from over. Moreover, with a growing portfolio of unsold homes, a sluggish economy, stubbornly high unemployment, the prospect of rising foreclosures, and billions in legacy losses, it appears unlikely in our view that housing and mortgage markets will be able to operate normally without continuing and substantial government involvement. That will likely mean further taxpayer support for Freddie Mac and Fannie Mae, the government-sponsored enterprises (GSEs) that, along with the Federal Housing Administration, now buy more than 90% of all home loans compared to less than half before the crisis.

That support has so far come at a price, which we believe is likely to rise substantially. Standard & Poor's estimates that the ultimate taxpayer cost to resolve Fannie Mae and Freddie Mac could reach $280 billion, including the $148 billion already invested--money largely spent to make good on loans gone bad. (Both GSEs are already in conservatorship.) That $280 billion, however, could swell to $685 billion, by our estimate, with the establishment of a new entity to replace Fannie and Freddie that the government would initially capitalize. Although federal authorities have taken no concrete public steps toward sponsoring a GSE alternative, Standard & Poor's believes that it's a useful exercise to consider how much such a recapitalization might cost taxpayers.

Our assumption is that it could cost an additional $400 billion to establish a new mortgage intermediary, capitalized at 7% of total assets -- although a smaller entity could be formed and capitalized based on risk-weighted assets. That $400 billion would, in our estimation, be enough to cover all losses and to support new business. We illustrate this cost at the 7% level. We are not aware that the regulators are targeting any specific capital levels. However, in the wake of the financial crisis, we believe more capital than may previously have been necessary will likely be warranted--especially if the government transfers ownership of this new institution to the private sector. If the government retained ownership, however, we estimate that the surviving entity could be capitalized as low as 4% of total assets, or about $225 billion. The taxpayers could bear the recapitalization for a purely government-owned entity, although private owners (e.g., financial institutions) could also capitalize it cooperatively.

In coming up with these estimates, we have also assumed that the future earnings capacity of such an entity can support provision and reserve levels for further originations. We did not, however, impute future dividends since we didn't project operating earnings or losses to make our estimates specifically comparable with those that the Federal Housing Finance Agency (FHFA; the primary regulator of the GSEs) recently released.

On Oct. 21, 2010, the FHFA projected that total Treasury draws by Fannie and Freddie could total $142 billion to $259 billion, excluding preferred dividend stock payments. The FHFA bases its approach roughly on the approach that the federal banking agencies took last year in the Supervisory Capital Assessment Program, which produced potential rather than expected outcomes.

However, we based our analysis of the potential total costs of supporting the GSEs purely on their publicly available financial statements. Fannie Mae and Freddie Mac have not provided or validated any of the assumptions that we have used. Our primary goal is to offer investors an independent view on our assessment of the remaining credit losses embedded in the GSEs.

A Backlog Of Unsold Homes Is Exacerbating The Housing Slump

The U.S. housing market remained in a severe slumpthrough the first three quarters of 2010. As a result, we see very little momentum toward a more steady housing market in 2011. Despite reports of stabilizing mortgage delinquencies at Fannie and Freddie, we believe there is significant uncertainty related to the build-up in inventory, which is likely to continue to keep home prices down (see chart).

But these numbers don't reflect the store of seriously delinquent loans that could go to foreclosure (often called the "shadow inventory"). Standard & Poor's estimates that at the end of second-quarter 2010, the shadow inventory backlog would have taken the market just over 40 months to clear (see "Second-Quarter Shadow Inventory Update: Liquidations Drop As Foreclosure Timelines, Modifications Increase" published Sept. 24, 2010 on RatingsDirect).

Moreover, we believe that Fannie Mae and Freddie Mac will continue to realize credit losses from their legacy portfolios over the next three to five years. The extent of those losses depend on, among other factors, the success of the newly initiated loan modification efforts and the ability to successfully resolve the foreclosure documentation issues that have arisen over the past few weeks. In addition, we are monitoring GSEs' success on their "put-back" efforts, i.e., their attempt to return to lenders mortgages they believe are based on representation and warranty breaches. We expect to see ongoing litigation over this contentious issue.

Key Assumptions And Methodologies For Our Estimate

In coming up with our estimate of as much as $675 billion to $685 billion as the potential cost to resolve Freddie Mac and Fannie Mae, we emphasize our view that it isn't sufficient to look solely at current losses. It's also necessary to consider what it might cost to capitalize a going concern(s) to carry out public housing policy as private enterprises. We built our analytical construct on two pillars: mortgage credit risk and counterparty credit risk. Mortgage credit risk considers the likelihood that borrowers will fail to make timely payments on mortgages they own or guarantee. Counterparty credit risk considers the likelihood of an institution failing to meet its obligations (specifically, derivative counterparties or mortgage insurers). Then, we applied our re-capitalization assumption to determine the total potential cost to resolve and relaunch both GSEs.

Credit portfolio

The GSEs guarantee about one-half of the total $10.6 trillion U.S. mortgage debt outstanding. Post-conservatorship, almost all of the GSEs' realized credit losses stemmed from the 2005 through 2008 vintages. We started our analysis by evaluating delinquency rates across that range of vintages (see table 1).

Table 1

Severely Delinquent Rates*
(%) Fannie Mae Freddie Mac
2005 7.2 5.7
2006 12.52 9.88
2007 13.79 11.05
2008 4.41 4.08
Aggregate portfolio delinquency 4.99 3.96
*As of June 30, 2010.

The 2005 and 2008 vintages are performing closer in line with the aggregate portfolio delinquency. So we focused on the 2006 and 2007 vintage portfolios and then applied a "rate analysis" based on the delinquency stage. For instance, we assumed that 25% of the loans that were less than 60 days delinquent would default (see table 2). For loans with longer delinquencies, i.e., 60 to 89 days, we assumed that one-half these borrowers would default. In both cases, we assumed that the severity of the loss on the home for the GSEs would be 50%. For loans in foreclosure, we applied a 15% severity rate assuming that these properties already have lower appraised amounts but may be cast into a soft market.

Table 2

Probablity Of Default And Losses
Status Expected probability of default (frequency) Expected loss given default (severity)
30-59 days past due 25 50
60-89 days past due 50 50
Severely delinquent (90+ days past due)* -- --
Foreclosure 100 15
Current 5 35
*See following text section.
Seriously delinquent borrowers

The unprecedented number of mortgage loans that are seriously delinquent (SDQ) -- more than 90 days past due -- has led to more intensive GSE efforts to put back loans to originators. Representation and warranty breaches are generally the justifications for put-backs. Adding to this volume is the fact that multiple unsuccessful modification programs have prolonged many mortgages' classification as SDQ versus going to foreclosure.

In our analysis, we made assumptions for both the potential that a loan would be successfully repurchased as well as the potential that it would be successfully modified. We base our assumptions on our observations of portfolio performance data and reviews of the experiences of each. To remove loans from the portfolio contributing to losses, the GSEs must successfully have them "put back" to the originators or modified so that the borrower can successfully meet their modified mortgage payments. We assumed that the GSEs will ultimately review 100% of seriously delinquent loan files to see if they are eligible for put back to their originators due to representations and warranties breaches. We also assume that the GSEs will review the remaining portfolio for possible modification eligibility or modification trial performance. (Ultimately, the borrower may redefault, which would put them back in the credit loss contributing pool.)

Step 1: Put-backs.   The first review for SDQ loans would be, then, whether they could be put back to an originator or issuer. We assumed GSEs can successfully put back 15% of the current outstanding inventory of SDQ loans to originators. This assumption includes the notion that the GSEs will get a 100% recovery of the loans that get repurchased.

Step 2: Modification eligibility.   Among the loans that are not subject to put-backs, we estimated around 65% could be eligible for modifications, while 35% would go straight to foreclosure due to their ineligibility. We ascribed a 100% default rate and a 50% loss severity on the loans that are ineligible for modifications. Separately, modified loans also tend to extend the timelines of delinquency and default.

Step 3: Modification redefault rate.   We assumed that only 20% of trial modifications would ultimately succeed. In assuming such a high failure rate on modifications, we reflect our belief that mortgage re-default is a significant risk. Nearly 40% of Freddie Mac's modifications have already been cancelled and about 50% of Fannie Mae's 2009 modifications re-defaulted within six months.

Step 4: Loss rates.   We estimate potential credit losses at the two GSEs of $200 billion to $220 billion. These losses exceed the current $99 billion combined reserve by $100 to $120 billion. These loss estimates reflect ultimate loss rates on the 2006 vintage of 6.2% and 6.7% for 2007. Overall, we expect the overall credit loss rate to be about 4.44%.

Step 5: Investment portfolio.   The GSEs are also vulnerable to additional losses in their investment portfolios from real estate-related securities. We see the greatest risk for potential negative surprises from non-agency residential mortgage-backed securities (RMBS) and, to a lesser extent, commercial mortgage-backed securities (CMBS). We define non-agency RMBS as subprime, option adjustable-rate mortgages, and Alt-A available for sale securities. To assess this risk, we assumed that 50% of the current unrealized losses (non-credit component of losses as of June 30, 2010) would result in a loss. If we apply this assumption, we conclude that the GSEs could lose 50% of their combined accumulated other comprehensive income in their private label mortgage-backed securities portfolios and CMBS portfolios for a total of $18 billion.

Step 6: Counterparty risk from mortgage insurance and derivatives counterparties.   Market conditions have constrained the liquidity and weakened the financial condition of a number of GSE counterparties, and may continue to do so. Over time, we believe that the growing stress on mortgage insurers of losses to honor claims will in turn further stress GSEs' credit performance. As of June 30, 2010, the GSEs had an aggregate $160 billion coverage outstanding on the single-family mortgage loans in their guaranty book. We have assumed that about 50% of the mortgage insurance receivables come from counterparties rated speculative grade. As a result, we apply a 10% credit charge against this portion of the receivables.

The possibility that a derivative counterparty won't be able to meet its contractual obligations is another factor that exposes Fannie Mae and Freddie Mac to credit risk. Typically, GSEs seek to manage this risk by contracting with well-rated counterparties ('A-' or higher) and also by requiring counterparties to post collateral. However, because of the concentration risk and increased confidence sensitivity of derivatives counterparties, we assign a counterparty risk exposure of 10% against derivatives exposures from counterparties rated below 'A-'. As a result, our derivative counterparty loss estimate totaled $8 billion.

Model limitations

We used a static model to assess the embedded losses in the GSEs' current portfolio. That is, we didn't try to estimate losses on prospective changes in their key loss variables. For example, we do not project growth in delinquent loans. Moreover, we do not calibrate our loss estimates to incorporate the sensitivity of credit performance to specific regions (such as the Southeast, which remains under significant stress), to unemployment, or to the basis loan values.

The Help A Stronger Economy Could Bring

It's no secret that a better economy would help ease the GSEs' predicament. More homeowners with jobs would likely translate into fewer bad mortgages and stronger home sales. But the tremendous supply-and-demand imbalance for homes is likely to offset any potential signs of home price stabilization. And, our assumptions indicate that there is a serious risk of default for homeowners who have had mortgage modifications. In addition, we see little chance of mortgage markets stabilizing without a revival in the securitization or secondary market, which would give more lenders greater flexibility. Fannie and Freddie comprise just one part of the complex machinery of the U.S. housing market. As it stands now, we believe that addressing the GSEs' problems is likely to be an expensive repair job for U.S. taxpayers.

Related Criteria And Research

Primary Credit Analyst:Daniel E Teclaw, New York (1) 212-438-8716;
Secondary Contact:Vandana Sharma, New York (1) 212-438-2250;

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