Barclays Equity Research analysts Mark C. DeVries, Jeremy Campbell, Terry Ma and Alan Tse highlight the implications of the Senate proposal on Fannie Mae / Federal National Mortgage Assctn Fnni Me (OTCBB:FNMA) and Freddie Mac / Federal Home Loan Mortgage Corp (OTCBB:FMCC) reform.

Fannie Mae Freddie Mac FHFA Federal National Mortgage Assctn Fnni Me (FNMA)

The Senate Banking Committee released a bipartisan agreement that outlined a proposal on potential housing finance reform (see “Johnson, Crapo Announce Agreement on Housing Finance Reform,” 3/11/14), which builds on the framework of the Corker-Warner bill. The proposal seeks to address several key issues, but in general, it will wind down Fannie Mae / Federal National Mortgage Assctn Fnni Me (OTCBB:FNMA) and Freddie Mac / Federal Home Loan Mortgage Corp (OTCBB:FMCC) and set up the Federal Mortgage Insurance Corporation (FMIC) as a new governing body. The proposal will set up a securitization platform that will create standardized FMIC-wrapped MBS, but also require that 10% private capital serve as the first loss piece and the creation of a mortgage insurance fund. In addition, the bill also seeks to address issues around underwriting standards, conforming loan limits, and affordable housing.

While the press release in its current form only outlines certain points, it is believed that something with a more definitive legislative language could become available in about a week, with a Committee vote to be followed the week after. Our read through is that the implications of the proposal are generally positive for the private mortgage insurance industry and also mortgage REITs under our coverage.

Fannie Mae, Freddie Mac: Proposal reaffirms mortgage insurance’s key role in housing market

The proposal requires mortgage insurance for loans with LTVs above 80%, which is in line with the current standard and reaffirms the key function of mortgage insurance. In addition, we believe the proposed 10% private capital requirement, which will be the first loss piece, could create an opportunity for the private mortgage insurers (PMI) to provide additional credit enhancement on top of the primary insurance they provide on loans with LTVs above 80%. A minor negative of the proposal is the requirement of a 5% down payment for home buyers (3.5% for first time home buyers), which will effectively reduce the highest premium business for the PMIs. However, we point out that none o the PMIs are writing much business above 95% LTV currently.

The Supply of Non-agency Mortgage Backed Securities May Increase

The proposal sets up a securitization platform that will create standardized FMIC-wrapped MBS. We believe the 10% private capital requirement may result in a subordinate non-agency MBS piece that will absorb the first loss prior to the FMIC wrapped piece, effectively increasing the supply of non-agency mortgages, which should be positive for hybrid and non-agency REITs. In addition, the proposal seeks to maintain liquidity in the TBA market by requiring the FMIC to consider the impact of new products on the TBA market. We think the net effect is a continued well functioning and liquid TBA market, which should be a positive for agency mortgage REITs as well.

The senate banking committee announced on March 11, 2014 it reached a bipartisan agreement on a proposal for housing finance reform (see “Johnson, Crapo Announce Agreement on Housing Finance Reform”). The proposal builds on existing framework of the Corker-Warner bill. While the press release is only an outline, it attempts to address some key concerns by participants. We believe something with a more definitive legislative language will become available in about a week, and a Committee vote could take place the week after that. We highlight some of the key takeaways from the press release below:

Fannie Mae and Freddie Mac: The proposal will effectively wind down Fannie Mae / Federal National Mortgage Assctn Fnni Me (OTCBB:FNMA) and Freddie Mac / Federal Home Loan Mortgage Corp (OTCBB:FMCC) and provide a benchmark and timeline to transition to a new system under the Federal Mortgage Insurance Corporation (FMIC).

Private Capital Requirement: While the agreement may set up the FMIC as an insurer of last resort, effectively creating a government backstop, the proposal will require private capital to bear a 10% first lost piece and also require the creation of a mortgage insurance fund.

Underwriting Standards and Conforming Loan Limits: The proposal will still keep the current conforming loan limits, but also require that loans backed by the government conform to the “qualified mortgage” (QM) definition and require a 5% down payment for homebuyers and 3.5% for first time homebuyers.

Securitization Platform: The proposal will set up a member owned securitization platform that will create standardized FMIC-wrapped mortgage backed securities as well as promote private label MBS to be issued in a standardized manner.

Mortgage Insurance: The proposal requires mortgage insurance (MI) for loans with loan-to-value (LTV) ratios above 80%. We note, this point was not in the initial press release, but brought up in a subsequent public staff briefing.

Affordable Housing: The proposal will undo affordable housing goals and create housing related funds to ensure that a supply of “decent housing” remains available. The funds will be paid for through a FMIC user fee of 10bps.

Implications of the proposal are positive for mortgage REITs

The press release only outlines the proposal and while the specifics are not clear, our read through is that it is generally positive for the private mortgage insurance industry and also the mortgage REITS. We believe the key implications are as follows:

Mortgage Insurance

The requirement to have mortgage insurance for loans with LTVs above 80% is consistent with the existing standard, and should reaffirm the key role private mortgage insurers play in the market.

In addition, there may be the potential for private mortgage insurance to participate in the 10% private capital requirement through pool level insurance, which should be a positive for the industry by increasing the opportunity set of writable business for the private mortgage insurers.

The 5% required down payment (3.5% for first time home buyers) may be a minor negative given it lowers the maximum LTVs to 95% and 96.5% and removes potential higher premium business. However, we note that none of the PMIs have been writing much insurance on loans above 95% LTV since the financial crisis, so it’s not clear this would be a meaningful constraint.

Mortgage REITs

We believe the 10% private capital requirement could result in a subordinate nonagency MBS piece being created, which will absorb the first loss prior to the Fannie Mae / Federal National Mortgage Assctn Fnni Me (OTCBB:FNMA) and Freddie Mac / Federal Home Loan Mortgage Corp (OTCBB:FMCC) wrapped security.

We think the net effect will be an increase in the available supply of non-agency mortgages, which should be a positive for hybrid and non-agency mortgage REITs. More specifically, with roughly $1tr per year of net Agency MBS issuance in the current environment, this could create an incremental $100bn of credit bonds a year.

The proposal will seek to maintain broad liquidity in the To-be-announced (TBA) market by having Fannie Mae / Federal National Mortgage Assctn Fnni Me (OTCBB:FNMA) and Freddie Mac / Federal Home Loan Mortgage Corp (OTCBB:FMCC) consider the impact of any new products on the TBA market, which should be a positive for agency mortgage REITs.