Government-sponsored entities (GSEs) Fannie Mae (OTCMKTS: FNMA) and Freddie Mac (OTCMKTS: FMCC) play a critical role. Without their services, guarantees, or federal funding, our mortgage and financing systems as we know them today couldn't operate. With this responsibility comes great risk and financial burden, which is why the Treasury and Federal Housing Finance Agency (FHFA) are moving away from the current conservatorship by federal agencies toward capitalization in the private sector. A recent ruling outlining new capital rules for the move into capitalization was made in January 2021. Here's what it means for investors.
How Fannie and Freddie work right now
Right now, Fannie and Freddie work with banks, financial, and lending institutions, buying and packaging groups or pools of mortgages together to create mortgage-backed securities (MBS), then guaranteeing the repayment of these loans and selling these loans to secondary buyers on the secondary mortgage market. Having a government guarantee helps reduce partial risk for buyers in the event of large-scale loan defaults as we experienced in the Great Recession and helps keep the banks and financing institutions that originated the loans liquid so they can continue to create more loans.
In 2008, following the Great Recession, the FHFA took over conservatorship, meaning the burden of keeping these entities liquid so they can maintain the services and guarantees they provide in the marketplace has been largely placed on the federal government, and thus a responsibility of the U.S. taxpayer.
The move into capitalization
Federally backed conservatorship was supposed to be a temporary fix to help "bail out" the industry in a time of need. It was never intended to be a permanent solution. Switching to capitalization, which means the entities would be funded and backed by private capital, is the long-term solution.
According to the new ruling, which has been established with the U.S. Treasury and FHFA, each GSE can issue up to $70 billion of common stock in efforts for capitalization. Investors purchasing shares in the entities will receive variable compensations until the capital reserve end date is met, at which time shareholders will receive quarterly dividend payments equal to the lesser of 10% of the liquidation preference of Treasury’s senior preferred stock, or the incremental increase in the GSE’s net worth in the prior quarter.
Since both entities hold hundreds of billions worth of shares and the new ruling requirements states exit from conservatorship cannot be completed until the GSE has common equity tier 1 capital of at least 3% of its assets, coming out of conservatorship will take time and likely won't be completed for several more years.