The Big Idea

Markets: Rising policy risk in mortgage finance

Steven Abrahams | May 14, 2021

This document is intended for institutional investors and is not subject to all of the independence and disclosure standards applicable to debt research reports prepared for retail investors. This material does not constitute research.

Investing in mortgage debt is about to get more complicated. A pending Supreme Court decision on the Federal Housing Finance Agency will likely give the White House the ability to replace the agency director at will, handing the executive branch a new measure of control over a large share of US mortgage finance. Policy risk is in play again across MBS, CMBS and beyond.

Don Layton spent three years as chair and then CEO of E*Trade and seven years as CEO of Freddie Mac, giving him a rare view of the interaction of politics and mortgage finance. In a recent essay, he argues last fall’s Supreme Court decision allowing the White House to replace the director of the Consumer Finance Protection Bureau will apply, too, in the case of the FHFA. The administration will find itself in control of a market regularly caught in political crossfire. To illustrate, Layton offers some examples clearly meant more to provoke than predict:

So, for example, as the FHFA is the conservator of the GSEs and not just their regulator, the White House could order an across-the-board lowering of GSE guarantee fees (G-fees), or an expansion of the credit box of the GSEs. But White House directions to different arms of the administration don’t just reflect pure and unconflicted policy concerns; there are everyday politics that are important as well. For example, the White House could order the FHFA to have the GSEs expedite approval of active multifamily loan purchase applications in a certain city because the president plans to visit there soon – a relatively benign example. Obviously, such orders can also be considerably less benign.

Layton puts most of his focus on the value of preserving the independence of FHFA and the best qualifications for an acting and permanent director, issues mainly of governance. But where Layton shows his long experience is in a tick-tock of specialized housing finance regulators—the Federal Home Loan Bank Board, the Office of Thrift Supervision, HUD’s effort to oversee Fannie and Freddie and FHFA’s own predecessor, the Office of Federal Housing Enterprise Oversight—that that did not have FHFA’s independence and ultimately became caught in politics. The concern in the shadows of Layton’s essay is that we are heading down that path again.

Layton has good grounds. With $11.7 trillion in outstanding 1-4 family residential debt and $1.7 trillion of multifamily debt at stake, it is the most politically sensitive debt market in the US. And the Biden Administration in the aftermath of the Supreme Court’s CFPB ruling has made no effort to reinstate a more acceptable form of CFPB independence. That suggests nothing will be forthcoming for FHFA. One Washington mortgage finance expert, who has held positions at the GSEs, HUD, FHFA and elsewhere since the 1980s said “It’s naïve to assume independence of an appointed director, especial if it’s the administration that put you in place.” If the Supreme Court rules the FHFA director serves at will, this expert said, “they’ve introduced politics back into the process.”

Layton notes that an acting replacement for current Director Mark Calabria by law can only come either from three current FHFA deputy directors or from among any Senate-confirmed appointees elsewhere in government. But three separate mortgage policy analysts suggested Sandra Thompson, currently FHFA Deputy Director of the Division of Housing Mission and Goals, would be the leading candidate. If the Supreme Court rules Calabria serves at will, the replacement could come within days.

A new acting or permanent FHFA director will almost certainly revisit recent decisions made by Calabria and make decisions in other areas with direct implications for agency and private MBS and CMBS. An acting director would likely slow or stop forward motion on things the administration views as harmful to its policy goals and leave the setting of new direction to the permanent replacement. Policy analysts see a few areas with market implications likely to be affected within the first six months to 12 months:

• Caps on investors loans and second properties. Recent revisions to the Preferred Stock Purchase Agreement governing conservatorship capped investor and second home loans sold to the GSEs by any originator at 7% of trailing 12-month volume. My colleagues estimate $8 billion to $10 billion of loans a month will need to find a new home. These loans generate between 2.125% and 4.125% in fees on delivery and help subsidize guarantee fees on loans to middle- and low-income borrowers, among others . Investor loans also increase the rental housing stock. And with the private market for now paying a lower price for these loans than agency execution, the cost of debt for investors has gone up. An acting director might push the deadline for compliance with the cap back to the original January 1, 2022 date, with a permanent director eliminating them.
• Limits on cash window use. The recent PSPA revisions also capped any originator’s use of the Fannie Mae or Freddie Mac cash window to $1.5 billion over any 12-month period. This seemed designed to reduce agency counterparty risk, since the window will provide cash to a seller on trade date instead of settlement date. By pushing non-banks to turn to bank gestation repo lines, origination costs and, likely, debt cost to borrowers will edge up. This also favors the very largest and the very smallest originators. This has a limited public audience but would play well among originators. An acting director might again suspend these limits pending review by a permanent director.
• Limits on agency multifamily volume. The PSPA revisions capped Fannie Mae and Freddie Mac multifamily acquisition to $80 billion each over any 12-month period. Last year Freddie Mac did $86 billion and Fannie Mae $76 billion. These limits would seem inconsistent with support for affordable housing. This would have a broad public audience. An acting director could delay enforcement pending review.
• Limits on purchases of loans with layered risks. The PSPA revisions also limited purchases of loans with combinations of high loan-to-value, high debt-to-income or low credit scores. These limits also likely have disproportionate affect on middle- and low-income borrowers, a broad audience. Look for delay pending review.

“Large chunks of things amended in the PSPA get reversed,” one analyst expects.

Other areas where policy would likely change in ways relevant to markets:

• Fannie Mae and Freddie Mac capital requirements and their impact on CRT. Capital rules finalized last November reduced earlier incentives for the agency to use credit risk transfers, and since the second quarter of 2020 Fannie Mae has issued none. Freddie Mac has continued. Although some policy analysts view CRTs as injecting capital markets credit pricing into mortgage finance and raising debt costs for riskier borrowers—something at odds with cross-subsidization—an important audience sees CRT as putting private capital in front of the taxpayer. Look for a new permanent director to reopen capital requirements and create new incentives for CRT.
• Restriction of Fannie Mae and Freddie Mac to repo against Treasury debt only. FHFA has recently instructed Fannie Mae and Freddie Mac to use monthly cash balances for repo against Treasury debt only instead of Treasury debt and agency MBS. Since January, the agencies have complied, joining a flood of other cash in the Treasury repo market and helping anchor SOFR at 1 bp since mid-March. This also subtly raises the cost of mortgage debt. This again has a limited public audience but still could get suspended by an acting director pending review.
• The 10 bp guarantee fee paid to the US Treasury. The Temporary Payroll Tax Cut Continuation Act of 2011 added this fee to help reduce the US deficit, and it expires this year on October 1. Even if it expires and is not replace through new legislation, an equivalent fee is widely expected to stay in place to fund affordable housing. An acting director could create a temporary new fee pending review.

All of these potential changes can sway the cost and supply and type of total mortgage debt, prepayment behavior in existing MBS, and can redraw the boundary between agency, non-agency and portfolio investments. It is opportunity and risk.

Layton argues for giving the FHFA full independence, appointing an acting director who will competently bridge the gap to a permanent appointment, and avoiding advocacy or politics in the final appointment. But others see FHFA and its control of Fannie Mae and Freddie Mac becoming more a part of the political currency in Washington.

“The downside of the last dozen years since conservatorship is that the GSEs and the mortgage industry are subject to more policy volatility with respect to their footprint and role with each change in power,” one analyst noted. “This really matters for both the provision of credit and the stability of the marketplace. This will be another step in that direction.”

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The view in rates

Very little changes these days in the very front end of the yield curve with SOFR pinned at 1 bp and the 30-day average of SOFR at 1 bp. Benchmark 3-month LIBOR has recently printed a historic low at 16 bp. Cash continues to swamp the money markets. Funding rates look likely to stay very low for very long.

The 10-year note has finished the most recent session at 1.63%, up 5 bp from a week before. The battle between rising inflation expectations and falling real rates continues. Inflation expectations continue to rise with 5-year breakevens up 2 bp on the week to 271 bp, 10-year breakevens moving up 4 bp to 254 bp and 5-year breakevens 5-years forward up 3 bp to 235 bp. Real rates, meanwhile, continue to fall suggesting some doubts in the rates markets about long-term growth and its ability to absorb an expected overhang of liquidity.

The Treasury yield curve has finished its most recent session with 2s10s at 148 bp, steeper week-over-week by 2 bp The 5s30s curve has finished at 153 bp, steeper by 8 bp.

The view in spreads

MBS spreads should stay tight and the dollar roll in MBS special. The nominal spread between par 30-year MBS and the interpolated 7.5-year Treasury yield closed recently at 64 bp, just 5 bp off the tightest level in MBS market history.

In credit, support from insurers and money managers should keep spreads tightening. Investment grade spreads have generally outstripped high yield on the back of bids from insurers and money managers, but high yield should get its due. Weaker credits should outperform stronger credits, with high yield topping investment grade debt and both topping safe assets such as agency MBS and Treasury debt. The consumer balance sheets has come out of 2020 stronger than ever—at least on average—and consumer credit should outperform corporate credit.

The big risk to spreads should come when the Fed starts making noise about approaching its targets for employment and inflation and tapering asset purchases. Keep those antennae tuned.

The view in credit

By the end of 2021, US GDP could be above levels projected before Covid for late 2021. That would represent one of the fastest and strongest rebounds from recession in US history. Consumers should continue to build strength. Aggregate savings are up, home values are up and investment portfolios are up. Consumers have not added much debt. Corporate balance sheets have taken on more leverage, although mitigated by strong cash balances and low interest costs. Corporations will need earnings to rebound for either debt-to-EBITDA or EBITDA-to-interest-expense to drop back to better levels. But strong economic growth in 2021 and 2022 should lift most EBITDA and continue easing credit concerns. Eventually, rising interest expense should compete with EBITDA growth. But not yet.