Market Musings

Global Rates, FX & Commodities Strategy 29 January 2019

► US ► RATES ► GLOBAL MARKETS

GSE Reform: Shots Fired Gennadiy Goldberg

Senior US Rates Strategist

• Recent headlines from interim FHFA Director Joseph Otting have suggested that
action on GSE reform may be coming even before Mark Calabria is confirmed by
the Senate.

• The FHFA and Treasury technically have the power to end the GSE
conservatorships without Congressional signoff. However, if the changes
threaten to undermine the housing market or decrease the availability of
mortgage credit in the US, Congress is likely to push back.

• Recent media reports suggest that the Trump Administration is likely to work
with Congress on GSE reform. In the meantime, the FHFA could finalize capital
recommendations, change the PSPAs to end the net worth sweep, and endorse
a GSE reform plan as a way of accelerating the process.

• The market impact of any GSE reform news will depend crucially on the issue of
grandfathering current MBS and debt, which we believe any attempt at housing
reform will have to include. Grandfathering existing debt and MBS would actually
help tighten spreads as it would suggest an explicit guarantee of the debt and
limited additional supply.

Action "within weeks"

We had recently discussed that the nomination of Mark Calabria for the role of Director of the Federal Housing
Finance Agency (FHFA) could trigger renewed discussions around GSE reform (see GSE Reform: Meet the
New Boss). Recent headlines from interim FHFA Director Joseph Otting have suggested that action on GSE
reform may be coming even before Calabria is confirmed by the Senate. Media reports have cited that at an
internal mid-January staff meeting Otting said, "In the next 2-4 weeks you’re going to be able to see some
communication that comes out of the White House and Treasury that really sets a direction for what the future
of housing will be in the US and what the FHFA’s part of that will be." Otting also pledged significant headway
toward an overhaul within "6-18 months."

The news sent shares of Fannie Mae and Freddie Mac to their highest levels since late-2016, when Treasury
Secretary Mnuchin hinted suggested that GSE reform is at the top of his to-do list (Figure 1). While MBS
spreads remained largely unchanged on the news, longer-dated GSE debt spreads briefly widened last week

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TD Securities Global Rates, FX & Commodities Strategy 29 January 2019 1

 Market Musings

as investors became concerned about potential disruptive changes. Media reports today suggest that the
Trump Administration will work with Congress to unveil changes to Fannie and Freddie soon.

The FHFA has denied that any timing or plans had been discussed, but we believe the change in leadership
suggests that action on GSE reform may be coming sooner than anticipated. Otting also noted that, "The
Treasury and White House viewpoint is that the [FHFA] director and the secretary of Treasury have tremendous
authority and that they would act, I think, independent of legislation if they thought it was the right thing to do."
Note that there has been little support in Congress for bipartisan housing reform, which could significantly
slow reform efforts. In the interim, there are a number of actions the FHFA and Treasury could take to kickstart
the housing reform process. As we noted in a prior publication, Treasury and FHFA can shrink the Fannie/
Freddie footprint by mandating further portfolio decreases, increased CRT, accelerating the UMBS program,
lowering conforming loan limits, and raising G-fees. In the absence of a broader GSE reform plan, however,
these changes could result in increased near-term volatility.

Figure 1: Fannie and Freddie Common Shares Have

Rallied Sharply Following Recent Otting Remarks
4.5
FM C C FN M A
4.0 Appeals
Mnuchin Court
3.5 Comments Decision

3.0

2.5 Otting
Remarks
2.0
Election
1.5

1.0
J S N J M M J S N J M M J S N J
2016 2017 2018
Source: Bloomberg, TD Securities

What can the FHFA and Treasury do?

The FHFA and Treasury technically have the power to end the GSE conservatorships without Congressional
signoff. However, if the changes threaten to undermine the housing market or decrease the availability of
mortgage credit in the US, Congress is likely to push back. This could include forcing FHFA and Treasury to
consult Congress prior to making significant changes (as was the case during the Obama Administration). GSE
reform is likely to be a long and drawn out process, but a number of changes by FHFA and Treasury could
speed a move toward an eventual end of the conservatorships:

• Finalize appropriate capital recommendations: As we have written previously, privatizing Fannie and
Freddie would entail raising a considerable amount of capital. In June, FHFA estimated that the Agencies
would collectively need approximately $181bn in total capital — higher than the $3bn capital buffers each
GSE is currently allowed to maintain (Figure 2). Building the capital organically (via retained earnings) would
take a long time given that the GSEs have earned about $15-20bn per year on average in recent years.

• Change the PSPAs to end the net worth sweep: Fannie and Freddie have collectively paid Treasury
$292bn against draws of $191bn (Figure 3). While these payments were dividends and not meant to be
considered repayments, the 2012 changes to the Preferred Stock Purchase Agreements instituted a net
worth sweep in which the GSEs paid Treasury their entire net worth each quarter. Since the sweeps were
instituted, the GSEs have paid Treasury a collective $227bn. If the PSPAs were revised to allow Fannie and
Freddie to retain some capital, this could set them on the path toward gradual reform. A more moderate

TD Securities Global Rates, FX & Commodities Strategy 29 January 2019 2

 Market Musings

approach could be to allow the GSEs to each keep $1-2bn per quarter and gradually rebuild their capital
bases. The PSPAs could also include a mandate for Fannie and Freddie to further shrink their retained
portfolios below the current $225bn limits (Figure 4). As of November 2018, Fannie's retained portfolio
totaled $184bn and Freddie's totaled $222bn.

• Endorse a plan for GSE reform: Previous FHFA Director Mel Watt refused to weigh in on GSE reform,
insisting that such recommendations were not part of the FHFA's mandate. Under new leadership, however,
the FHFA and Treasury could lay out a proposed plan for GSE reform, which could be modeled on previous
proposals such as the MBA plan. While there have been a number of reform proposals, the MBA roadmap
has gradually emerged as one of the leading plans. This plan would ensure that MBS are issued through
the Common Securitization Platform (CSP) while Fannie, Freddie, and other chartered guarantors provide
catastrophic mortgage insurance. As part of this plan, the GSEs would become regulated private utilities.
FHFA and Treasury would need to lay out a reasonable time frame for the transition (which we believe may
be as long as 5-10 years in order to avoid disruptions in the housing market) and address the potential
transitional structure. Note that the MBA plan includes a number of potential options for the transition, calling
for the grandfathering of current debt and MBS. Markets will be paying particularly close attention to this
issue as grandfathering would explicitly guarantee existing debt, tightening spreads.

Obstacles to reform
While the prior changes can be made by the FHFA and Treasury without Congressional signoff, any perceived
overreach could trigger a backlash from Congress. This is likely why recent headlines suggest that the
Administration will look to work with Congress on reform plans. We see a number of factors that could slow any
near-term action on reform:

• Congressional pushback: Maxine Waters, the head of the House Financial Services Committee, has
already requested that Otting provide the committee with "a detailed description of the mission that Treasury
and the White House" have for housing finance policy by February 1. Any significant pushback from House
Democrats could make it difficult to involve Congress in future reform efforts, stalling progress.

• Potential Calabria complications: While the Republicans have a majority in the Senate, a GSE reform plan
that is perceived as overly detrimental to the already fragile housing market could complicate Mark Calabria's
nomination process. Note that housing is an issue that is divisive even within parties, potentially slowing
Calabria's approval. This suggests that a detailed housing reform plan may only be released after Calabria is
confirmed by the Senate.

TD Securities Global Rates, FX & Commodities Strategy 29 January 2019 3

 Market Musings

• Suspending dividends could trigger backlash: Fannie and Freddie collectively earned about $15-20bn
per year on average in recent years. Allowing the GSEs to retain some of this capital could have negative
deficit implications, potentially creating pushback from Congress as deficits are already projected to increase
in the coming years.

Market impact
The market impact of any GSE reform news will depend crucially on the issue of grandfathering current MBS
and debt, which we believe any attempt at housing reform will have to include. The grandfathering of existing
debt and MBS would actually help tighten spreads as it would suggest an explicit guarantee of the debt and
limited additional supply. However, any plan that does not grandfather existing securities and threatens housing
market stability would likely widen debt and MBS spreads. Thus far, there has been little reaction in MBS and
only a temporary widening in longer-term GSE debt spreads.

While we believe that any plan will have to guarantee current debt, we see an increased risk of near-term
volatility in debt and MBS spreads as the market absorbs further news on reform. Given our view that any
further reform efforts will require a further wind down of the retained portfolio and the grandfathering of current
securities, we believe supply scarcity will continue to keep spreads tight over the medium term. In fact, as we
noted in our 2019 Outlook, we expect GSE supply to remain negative in 2019 (declining by $25bn), maintaining
the tailwind for spreads.

TD Securities Global Rates, FX & Commodities Strategy 29 January 2019 4

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