Citi Research released a research report today titled “Outlook on US Housing Finance”. Citi analysts Keith Horowitz, Donald Fandetti and Will Randow outline the five major factors impacting the U.S. housing market in 2014: Fannie Mae / Federal National Mortgage Association (OTCBB:FNMA) and Freddie Mac / Federal Home Loan Mortgage Corp (OTCBB:FMCC) reform, new regulations, higher costs and capital and the transition from a refi to a purchase market.

Fannie Mae FHFA

Fannie Mae and Freddie Mac’s reform

There has been talk for years about reforming, or even dismantling, GSEs such as Fannie Mae / Federal National Mortgage Association (OTCBB:FNMA) and Freddie Mac / Federal Home Loan Mortgage Corp (OTCBB:FMCC), but there has been little action to match the talk to date. That, however, might be changing, as bipartisan momentum for GSE reform seems to be building. President Obama and a number of Democrats have come out in support of reforming Fannie Mae and Freddie Mac and nearly all of the Republican caucus backs the idea.

The devil is in the details

Horowitz et al. point out that Fannie Mae / Federal National Mortgage Association (OTCBB:FNMA) and Freddie Mac / Federal Home Loan Mortgage Corp (OTCBB:FMCC) reform is a thorny issue, and must be addressed systemically to avoid possible negative ramifications the U.S. housing market, including the potential for the demise of the 30-year mortgage:

“We do not see a specific trigger for Fannie Mae / Federal National Mortgage Association (OTCBB:FNMA) and Freddie Mac / Federal Home Loan Mortgage Corp (OTCBB:FMCC) reform, but it seems likely due to bipartisan support to reduce taxpayer exposure. One avenue to bring in private capital is through balance sheet retention, and banks are retaining adjustable rate mortgages (est ROE of 12 – 13%), but have significantly less appetite for 30-yr fixed rate (~80% of market) due to interest rate risk. In order to maintain the 30-yr, GSE reform will need to require a securitization solution and include an explicit government backstop to maintain the TBA market, which is essential to mortgage market liquidity. We believe the proposal of having private capital absorb the first 5 – 10% loss and government taking the tail risk is feasible and should only have a limited impact on mortgage spreads (10 – 40 bps)…”

Fannie Mae Financing System

Post-reform economics of mortgage banking

The report emphasizes that higher capital requirements are already planned for in most cases, and almost any reform that materializes (short of abolishing GSEs with no replacement) is not likely to have a significant impact on mortgage industry players or their basic business model. The mortgage origination business will continue to be basically breakeven, and used as an entree to the more profitable mortgage and customer servicing business that financial institutions are really looking for.

“Non-banks with scale will be the beneficiaries, earning ~20% ROEs. Lastly, we see opportunities in credit risk mgmt for fixed income investors to participate in risk-sharing deals with potential returns of ~7.5% vs 5-6% for securities of similar quality, a potentially large opportunity for mortgage insurers, and niche lenders with superior analytics to identify attractive risk/reward in non-QM space.”

Fannie Mae 2 chart