Evaluating possible privatization of Fannie Mae and Freddie Mac

Chris Helwig | February 14, 2025

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.

There is growing consensus in the mortgage market that the new administration will take a run at releasing Fannie Mae and Freddie Mac from conservatorship. Given their central role in the mortgage, debt and derivatives markets and in housing finance, it could have broad impact on markets and the economy. Transferring them from government to private hands would be extremely complex. Treatment of existing government interests, the nature of any government support and required amount and return on capital are all key considerations. The US will have to weigh potentially increased uncertainty and costs to US homeowners against the benefits of privatization.

Any path to privatization would need to address multiple key issues:

• Treatment of the government’s existing interests in the enterprises. The value of Treasury’s investments in the enterprises currently amount to $340 billion. Practically, fully repaying both the government and private investors while also raising enough equity to properly capitalize the enterprises appears untenable, suggesting the government may have to concede to a partial recovery of its interests.
• Structuring the government guarantee post conservatorship. Government support for the re-privatized enterprises could be explicit, implicit or non-existent. An explicit guarantee could broadly preserve current market structure and possibly lower mortgage costs but would require the administration to work with Congress to get it done. Implicit or non-existent guarantees would likely raise mortgage costs.
• Preservation of the UMBS and TBA markets. Originators’ ability to efficiently sell both interest rate and credit risk through the TBA market is an integral component of US housing finance. Privatization of the enterprises as separate and independent companies could signal a return to a less efficient, bifurcated, smaller TBA market.
• Right sizing capital and returns. In any privatization scenario, the enterprises would have to raise substantial equity capital through a public offering. Balance sheet leverage and the availability of adequate revenues and returns to attract capital will have implications for both the size and composition of the enterprises’ post conservatorship balance sheets as well as the cost of mortgage debt.

Treatment of the government’s preferred equity and warrants

One requirement of any release of the enterprises from government conservatorship is the need to extinguish the Treasury Department’s standing interests in them through the Preferred Stock Purchase Agreements (PSPAs), first executed between Treasury and the enterprises in September of 2008. Based on the capital structure created under the original PSPAs, income generated by the enterprises would first go to pay a preferred stock dividend of 10%. Of any funds left over, 79.9% would go to Treasury with the remaining 20.1% going to private holders of existing preferred shares in the two companies. Treasury’s share in residual income represents warrants struck at a fraction of a penny and expiring on September 7, 2028, which gives them the right to purchase 79.9% of the outstanding common shares of the GSEs.

For several years following the original agreements, the enterprises’ dividend interest expense outstripped earnings. The agreements consequently were amended in 2012 to a ‘net worth sweep’ where both Fannie Mae and Freddie Mac would remit 100% of their net income to Treasury rather than pay a fixed dividend. This change solved the problem that the enterprises were digging a deep hole in their balance sheets because of their inability to cover dividend obligations under the original agreements, effectively drawing more capital from one pocket at Treasury to pay back a different one.

Fast forward to today and the Treasury’s interest in the enterprises, warrants notwithstanding, totals $341 billion—$212* billion and $129** billion for Fannie Mae and Freddie Mac respectively. Treasury’s interest, known as the liquidation preference, is calculated based on the enterprises’ net worth, and will continue to grow assuming the companies remain profitable and continue to retain earnings. Collectively, the liquidation preference represents $190 billion face value of senior preferred equity purchased in 2008 and issued before the GSE’s conservatorships along with the value of additional senior preferred equity injected through the PSPA.

The implementation of the net worth sweep has introduced room for an alternative interpretation of what the enterprises ‘owe’ to Treasury. Applying the original terms of the PSPAs, Fannie Mae took capital draws totaling slightly less than $120 billion and has subsequently paid back north of $180 billion. Freddie drew slightly more than $71 billion and has paid back almost $120 billion according to fiscal year 2023 filings. This analysis suggests that the enterprises have already paid back Treasury’s investment with interest, implying that the economic hurdle to privatization is vastly reduced and is merely comprised of the $35 billion owed to private preferred holders and any additional capital required by a binding minimum leverage requirement.

Based on the companies’ third quarter earnings, Fannie Mae had total equity of $90.5 billion and Freddie Mac had $56.4 billion, roughly $200 billion shy of the liquidation preference even before accounting for the $35 billion in outstanding privately held preferred shares. Absent Treasury’s willingness to curtail some of its interests, the enterprises may not be able to raise the requisite equity needed to privatize in the near future.

This begs the question as to why government stakeholders would be willing to release the enterprises at some haircut to the value of their interests. It’s certainly plausible that key decisionmakers may see conservatorship as already having paid substantial dividends and that a partial recovery in the near term may be as good an exit strategy as any. Additionally, certain recapitalization scenarios would yield a full repayment of the $190 billion in initially purchased senior preferred shares and a valuation of the common equity warrants of anywhere from $37 to $271 billion, according to analysis by the Congressional Budget Office (Exhibit 1).

Exhibit 1: CBO estimated recovery for GSE senior, junior preferred and warrants

Source: Santander US Capital Markets, Congressional Budget Office “An Update to CBO’s Analysis of the Effects of Recapitalizing Fannie Mae and Freddie Mac Through Administrative Actions,” December 2024

To guarantee or not to guarantee

Another critical sticking point is whether the spinout of the enterprises from conservatorship would come with an explicit guarantee on existing and future MBS and debt issued. An explicit guarantee on MBS and debt can only come through an act of Congress, precluding the administration from unilaterally releasing the enterprises from conservatorship while maintaining the current market structure. While it’s unclear how much support a government backstop for newly privatized entities would garner, there is a reasonable case. A February 10 report from Moody’s ratings notes that “even at conservatorship exit, we believe senior unsecured bondholders are likely to continue benefiting from significant implicit government support because the GSEs’ roles are likely to remain crucial to the US mortgage market,” Given how enmeshed the enterprises are in US housing finance, it seems unlikely that the government would allow them to fail in the case of insolvency, and an explicit guarantee that the government is being appropriately compensated for appears to be a better option than an implicit one.

The absence of an explicit guarantee would likely have significant ripple effects. At an absolute minimum, the absence of a government guarantee will drive the enterprises’ cost-of-funds higher as their debt will be evaluated solely on the strength of their fortress balance sheets, likely creating the need to raise guaranty fees to generate an acceptable return on capital. Assuming solely based on the strength of their balance sheets the enterprises would be rated somewhere between ‘AA’ and ‘A’, their unsecured cost-of-funds could rise by 40 bp to 65 bp given unsecured funding spreads on comparably rated financial institutions.

According to Moody’s recent analysis, the rating agency assumes a reduction in the government support for the enterprises would translate to a one to three notch downgrade in the enterprises’ long-term debt ratings. Additionally, the absence of a government guarantee would introduce substantially more spread volatility into the enterprises’ cost-of-funds. Wider funding spreads will ultimately manifest in higher mortgage rates as the GSE’s primary objective morphs from lower cost, mission-based credit availability for US homeowners to generating an acceptable return on capital for their stockholders.

MBS spreads would almost certainly widen absent an explicit guarantee. The presence of existing, future and contingent capital is, in all likelihood, not viewed by MBS investors as equal to the existing guarantee of timely principal and interest. Changes to the risk weighting and liquidity coverage treatment of conventional MBS and CMOs would likely weigh on the utility of agency MBS in domestic depositories’ portfolios.  Furthermore, the absence of an explicit guarantee could take away a key policy tool in the Fed’s tool kit. A drawdown in stable demand from depositories coupled with potential curtailment of the Fed’s ability to purchase MBS to stabilize market conditions would almost certainly increase spread volatility, particularly in stressed market conditions. Additionally, certain public and private foreign investors may look to convert their conventional holdings to Ginnie Mae MBS absent an explicit guarantee.

If the enterprises are released from conservatorship without an explicit guarantee, the impact to conventional MBS spreads should be governed by whether they are released with an implicit guarantee, akin to the pre-GFC market structure or no guarantee at all. And while difficult to quantify, observations of MBS spreads around downgrades of the long-term debt of the US by major rating agencies may prove to be a reasonable guidepost.

On August 5, 2011, S&P downgraded the US federal government from ‘AAA’ to ‘AA+’. In the trading sessions following the downgrade, MBS Index OAS widened by 15 bp (Exhibit 2). Releasing the enterprises from conservatorship with an implied guarantee could spark a similar move wider in mortgage spreads but would likely be driven to some degree by the weight rating agencies put on the implied guarantee and subsequent ratings downgrades. Releasing the agencies from conservatorship without any government support over and above the liquidity afforded them by their charters and the PSPAs should drive spreads materially wider.

Exhibit 2: MBS Index OAS widens on US downgrade

Source: Santander US Capital Markets, Bloomberg LP

Can UMBS survive if the enterprises are privatized?

Privatization of the enterprises into discrete companies could disrupt the liquidity of the uniform TBA contract. Before the launch of UMBS in 2019, the TBA market traded separate Fannie Mae and Freddie Mac contracts. Freddie Mac contracts, by and large, traded at a discount to Fannie Mae based on a combination of perceived and empirical differences in convexity and liquidity. The privatization of the enterprises could drive differentiation in their business models, potentially creating more pronounced differences in convexity and credit and worsening the UMBS TBA deliverable, driving MBS spreads wider. Removing the fungibility of the TBA market would likely introduce increased costs for both originators and the enterprises, which ostensibly would be passed on to borrowers in the form of higher mortgage rates.

Privatization of the enterprises could potentially even call into question the viability of the forward market, a critical element of the mortgage market structure. Through the TBA market, originators are able to sell forward both the credit and interest rate risk on their pipelines of locked loans. The ability to sell this risk forward reduces the cost to originate loans by reducing financing and hedging costs that originators would otherwise bear if they were only able to sell funded positions. At an absolute minimum, privatization could impair the size of the TBA market.

Under the current regulatory framework and market structure, exposure to a single counterparty is capped at 15%, however, the GSEs are afforded a broad- based exemption. Capping large banks exposure to the enterprises would likely have implications for the size of the TBA market as depositories may have to downsize their exposures to align with counterparty exposure caps for private companies. Moreover, the release of the enterprises without an explicit or implied government guarantee could substantially impair the size and liquidity currently afforded by the TBA market as counterparties may look to reduce exposure to the enterprises based solely on the merits of their fortress balance sheets.

Projecting capital and returns for the newly formed enterprises

There are divergent opinions as to the appropriate level of capital for newly privatized GSEs. GSE capital ratios will ultimately inform projected levels of return on that capital, the strength of their fortress balance sheets and subsequent implications for their credit ratings, as well as other considerations. Market participants advocating for lower capital ratios by and large view the enterprises as insurance companies who actively reinsure some portion of the credit risk they guarantee through both capital markets and traditional reinsurance credit risk transfer programs. Those advocating for more stringent capital rules generally view the enterprises more like systemically important depositories than insurance companies, requiring them to hold capital consistent with regulatory minimums for single family mortgage loans, potentially with some additional overlay given the systemically important nature of the enterprises.

A key differentiation between the enterprises in their current form and systemically important depositories is that large banks maintain sizable investment portfolios while the GSEs do not, particularly in the context of the size of their balance sheets. The application of more stringent capital ratios could introduce both the ability as well as the need to lift the caps currently imposed on the size of their portfolios.

At the end of the third quarter, Fannie Mae held just over $4.3 trillion in assets while Freddie Mac held just over $3.3 trillion. The enterprises held $90.5 and $56.4 billion in capital, generating capital ratios of 2.09% and 1.69% respectively. Assuming the enterprises would have to maintain capital ratios roughly in-line with regulatory minimums for monoline residential mortgage exposures for US depositories suggests that they may have to increase capital ratios to 4.0%. This would, in turn translate to roughly $170 billion in additional capital that the enterprises would have to raise (Exhibit 3).

Exhibit 3: Pro-Forma GSE balance sheets post recap & release

Source: Santander US Capital Markets, Fannie Mae, Freddie Mac, Bloomberg LP

The 4.0% threshold may serve as the lower bound for recapitalization as it represents a 50% risk weighting on an adequate regulatory minimum of 8.0%. For practical purposes, large and systemically important financial institutions operate well above the regulatory minimums given more stringent regulatory requirements including G-SIB surcharges and stressed capital buffers.

In either instance, raising that amount of capital would substantially dilute the enterprises return on capital given current levels of net income. Given this, the GSEs could grow net income in one of three ways. First, they could grow the amount of mortgages they insure or apply a broad-based increase to the cost of that insurance in the form of the base guaranty fee, neither of which appear likely. Increasing the population of loans they guaranty would run counter to the likely desire to shrink the role of the enterprises in US housing finance and raising the guaranty fee would further increase the cost of homeownership. This potentially leaves growing the investment portfolios as a viable albeit potentially politically unpopular one, particularly if the enterprises were spun out with explicit guarantees.

Does privatization accrue a demonstrable financial benefit?

Determining whether privatization generates a positive financial benefit is a complex analysis and largely hinges on whether the enterprises are viewed as public or private companies. Two entities within the government are tasked with tracking government expenditures the Congressional Budget Office (CBO) and the White House Office of Management and Budget (OMB). Put simply, the OMB views the enterprises as private companies despite conservatorship and see them trimming the deficit by roughly $70 billion over the next ten years. Conversely, the CBO views the GSEs as part of the government that will generate a $50 billion liability over the same horizon. Ultimately, the CBO’s framework would drive potential impact to the budget through a process known as reconciliation. There may be some incentive for a legislative solution where the privatization of the GSEs would provide an offset for extension of existing or future tax cuts that the administration may be contemplating.

Adding another layer of complexity to whether privatization would prove to be a windfall to the government is the potential value tied to the Treasury’s warrants through an initial public offering. Per the CBO’s analysis issued in December, the projected value of the warrants if they were to exit conservatorship in 2027 could be upwards of $200 billion. However, that valuation is predicated on a relatively low level of both required capital and return on that equity, at 3.0% and 8.0% respectively. A more conservative assumption suggests the warrants could be worth roughly $37 billion if the enterprises retained earnings through 2028 and brought a public offering to market in the beginning of 2029, targeting a capital ratio of 4.0% and a 10% return on equity. However, the CBO analysis does not incorporate the expiration of the warrants in September 2028. In practice, the government might have to come to market before expiration, changing the calculations.

What’s the policy goal of privatization?

Away from any potential albeit ambiguous financial benefits, a move towards privatization should come with a clearly articulated policy goal. Prior to 2021, policy under conservatorship was stewarded by an independent director of FHFA, who could not be replaced by the administration except for cause, providing some element of ballast and continuity to policy goals. The Supreme Court’s watershed ruling in Collins v. Yellen decided the director of FHFA should serve at the discretion of the administration, affording the executive branch the ability to appoint a director that could re-strike policy to more closely align with a new administration’s agenda, introducing greater volatility of policy goals. Privatization with a clear policy agenda theoretically could stabilize GSE policy as policy would primarily be handed down by the companies’ board of directors on behalf of shareholders and overseen by a newly appointed regulator.

In the wake of the GFC the resounding argument for privatization centered around the risk the enterprises posed to the US taxpayer if there were another comparable market downturn. However, the enterprises, through the PSPAs and other non-legislative actions have been materially de-risked while in conservatorship. The enterprises’ guarantee books have been de-risked through changes to loan level pricing adjustments on certain types of loans and the transfer of meaningful swaths of retained credit risk through both capital markets and traditional reinsurance programs. Furthermore, the GSEs’ retained portfolios, a large driver of mark-to-market losses, are mere fractions of the sizes they were prior to the GFC. These structural changes to the companies have materially weakened the argument that they pose a comparable risk to the US taxpayer that they did in the runup to the GFC.

If the risk to the taxpayer is demonstrably lower, policy goals are likely localized to whether privatization may reduce the cost of homeownership and if the enterprises current footprint affords enough opportunity for other sources of private capital to compete. Put simply, there is almost no plausible scenario where absent a full-faith-and-credit guarantee, primary mortgage spreads to Treasury rates tighten, resulting in a lower cost to borrowers. One potential goldilocks scenario would be a structure where the enterprises were released with explicit guarantees and allowed to grow their investment portfolios. In this instance, equity investors would accept a lower return on capital given the de-risking of that equity through the guarantee. Lower return hurdles would be less disruptive to current guarantee fee pricing and additional net demand from larger GSE portfolios could drive the secondary mortgage basis tighter, pulling primary mortgage rates lower as secondary spreads tighten.

If the primary goal of recapitalization is to introduce more private capital into US housing finance, there are far less operationally complex and convoluted ways to do so with far less systemic risk. There are numerous sizable areas of the mortgage market where the enterprises currently compete with private capital that are, at a minimum, not consistent with mission objectives. Lowering conforming loan balances or terminating conforming jumbo programs which expand delivery eligibility to 150% of conforming balances for certain high-cost areas would be easy places to trim the GSE footprint. Additional credit overlays for non-owner-occupied loans would drive more investor and second home loans to insurance company balance sheets to private label conduits.

In conclusion

Rhetoric from key mortgage market participants offer conflicting views on the prospects for privatization. Just last week Scott Turner, the newly appointed head of the Department of Housing and Urban Development, said a cross-government effort to privatize the GSEs will be a priority of his. Subsequently, Treasury Secretary Bessent, who maintains a far more influential role in privatization efforts given the fact that the PSPAs are agreements between Treasury and the enterprises, stated that any privatization efforts would be evaluated in terms of the impact on mortgage rates. If, in fact, the implications for mortgage spreads are the governing factor in driving privatization efforts, it’s hard to see a scenario where privatization brings lower rates absent an explicit government guarantee. This, in turn, means that there would have to be broad-based support from both the administration and Congress, suggesting that while there may be substantive efforts to privatize the enterprises, they may ultimately fall short.

* The aggregate liquidation preference of the senior preferred stock will further increase to $212.0 billion as of December 31, 2024, due to the $4.0 billion increase in our net worth in the third quarter of 2024. See “Business—Conservatorship and Treasury Agreements—Treasury Agreements” in our 2023 Form 10-K for more information on the terms of our senior preferred stock, including how the aggregate liquidation preference is determined.

** The quarterly increases in net worth have been, or will be, added to the aggregate liquidation preference of the senior preferred stock. The liquidation preference of the senior preferred stock was $125.9 billion on September 30, 2024, and will increase to $129.0 billion on December 31, 2024 based on the increase in net worth in 3Q 2024.