One of the concerns for Fannie Mae and Freddie Mac some have raised is how they will be able to make money when they are recapitalized and released from conservatorship. Understanding how the government-sponsored enterprises make money now is the key to knowing how they will be able to keep conducting business when they are released.
Investors won't want to invest in companies that can't make money, so this is an important issue to understand.
Here's how Fannie Mae makes money now
In an interview with ValueWalk, Tim Pagliara and Grant Stark of CapWealth Advisors explained how Fannie Mae and Freddie Mac make money. Pagliara explained that the GSEs make money on every mortgage they resell. In fact, they make so much money that they are two of the most stable companies in the world.
Top value fund managers are ready for the small cap bear market to be done
During the bull market, small caps haven't been performing well, but some believe that could be about to change. Breach Inlet Founder and Portfolio Manager Chris Colvin and Gradient Investments President Michael Binger both expect small caps to take off. Q1 2020 hedge fund letters, conferences and more However, not everyone is convinced. BTIG strategist Read More
"If you are an investor and you buy Fannie Mae mortgages that have been packaged up by Fannie Mae and Freddie Mac, and you're getting a 3.5% return on it," Stark said. "That's the net return. The actual mortgage itself is closer to 4% so one half of one percent of that mortgage is retained by Fannie Mae and Freddie Mac. That's what they use to pay overhead and a source of revenue for building capital and covering losses."
He added that taking half of a percent on the $6 trillion mortgage market amounts to $30 billion per year in pretax earnings. Further, this is recurring revenue, which makes the GSEs extremely stable, so that $30 billion covers losses and additional capital reserves. He expects that some of that $30 billion will also go to pay dividends to shareholders once the dust settles after they exit conservatorship.
Reduced product lines
A key issue that has been raised with Fannie Mae and Freddie Mac is the products they have stopped offering due to changes by the Federal Housing Finance Agency. Some have taken those changes to mean that the GSEs won't be able to make money after being released from conservatorship because their product lines have been reduced.
Thus, questions about how Fannie Mae and Freddie Mac will make money then have surfaced. However, Pagliara argues that it's actually a good thing that the GSEs' product lines have been slimmed down because it reduces their risk.
He also said Fannie and Freddie are unique within the lending industry because they don't have a wide range of lending activities that require different kinds of analysis and are subject to different types of risk.
"They're strictly mortgages," he said. "Some of the things Fannie Mae and Freddie Mac used to do were riskier activities: arbitrages and other things. They're not going to be able to do some of those things. They were very profitable, but they were also risky. So if you eliminate the things that were profitable and also risky, you also reduce the amount of capital they have to have to support the enterprise."
He explained that the key is to maintain liquidity in the mortgage market, and no one does it better than Fannie and Freddie. Thus, it only makes sense to recapitalize and release them from conservatorship rather than to scrap them and start over. It also explains why officials must protect the GSEs and ensure that the release process is successful.