When Freddie & Fannie Spend $200 Billion on Delinquent Mortgages... (FNM, FRE)

The government is slowly winding down its added liquidity additions via mortgage and securities purchases from banks and lenders.  Sort of.  Ben Bernanke’s outline of how to exit the end of free money and zero-rates only indicated that the end of the policy would ultimately come.  But on Wednesday came word that Fannie Mae (NYSE: FNM) and Freddie Mac (NYSE: FRE) would repurchase up to $200 billion in delinquent mortgage loans.  Surprise, surprise.  Many wanted to know why Uncle Sam hasn’t just gone from a conservatorship to just foreclosing on the GSE mortgage lenders.  Simple, our government can’t absorb this as a direct balance sheet item…. It takes a little while figure out just what the $200 billion really means to the delinquent mortgage market.  Expect a lot of new mortgage-backed security prepayments are coming… some at losses.

The two agencies can purchase up to about $200 billion worth of delinquent home loans from investors who own the underlying mortgage-backed participation certificate securities.  One of the catalysts is accounting rules that have gone into effect this year requiring financial institutions to keep all performing and non-performing loans on the balance sheets.  Effectively, Fannie and Freddie can guarantee the return of principal and interest on delinquent loans, but it is actually cheaper to repurchase these from investors.

Fannie Mae can purchase loans which are delinquent by four-months or more from its mortgage-backed securities pools.  Investors will be able to get their principal back earlier at the Par value.  Here is where it gets tricky.  The sudden prepayment will generate some losses as some of these are higher mortgage rates than current Par mortgages.

After doing some digging around, it looks like this is a follow-up of a promise or an ability from almost three-years ago that some of these would be repurchased if it was cost effective.  NASDAQ’s news site, using the WSJ, used a figure of four-months or more delinquent at ‘about $127 billion.’

The Freddie Mac purchases would be in February and a published report will be made in early March.  The Fannie Mae figure is being put at $127 billion for the 4-month or more in delinquent mortgages, but that figure is also now based on data that is six-weeks old.  Fannie Mae’s purchases will occur in March and be completed in April.

Where this gets interesting is that this is represented as preserving capital and as cutting what will be drawn down at the Treasury by Fannie and Freddie.  The loans have to go back to the balance sheet and purchasing these delinquent loans effectively keeps these from being written-down significantly.

The long and short of the matter is that mortgage-backed securities investors are about to be getting back billions and billions in principal.  Some of these are higher coupons, so the reinvestment rate will be lower and may create some losses on the portion of the pools that are purchased.  This may also create a spike up in PSA or CPR rates for two to three months, followed by an immediate slowing of prepayment speeds.

Accounting changes often create opaque opportunities.  When you cross the accounting changes with Uncle Sam and the mortgage-backed securities markets, deciphering the data sometimes sounds more like philosophy than math.

JON C.OGG