What happens to Fannie, Freddie, Rates in budget impasse?

What happens to Fannie, Freddie and mortgage bond/rate markets in a budget stalemate? Under the Housing and Economic Recovery Act of 2008, if an Enterprise’s liabilities exceed its assets under GAAP the Treasury provides sufficient capital to eliminate that deficit in exchange for senior preferred stock. Fannie and Freddie have received capital from the Treasury under this agreement over the past several quarters – but what happens if one or both lose money in the 2nd quarter, and request more money and we don’t have a higher debt ceiling?

As a few Wall Street research departments point out, HERA 2008 has a “mandatory receivership” clause for Fannie and Freddie which takes them out of conservatorship if certain conditions are met concerning assets versus obligations and lack of ability to pay debts. Fannie’s 10-Q for the first quarter states, “FHFA has an obligation to place us into receivership if the Director of FHFA makes a written determination that our assets are less than our obligations for a period of 60 days after the filing deadline for our Form 10-K or Form 10-Q with the SEC.” It is highly unlikely that the debt ceiling will not be raised before the possibility of Fannie & Freddie moving from conservatorship to receivership becomes an issue. But every day that the government fails to put forth a plan, concerns such as this one will arise, making investors a little more leery.

Others are saying, though, “Without some sort of serious entitlement reform, we’re likely to lose our AAA rating. Does that really matter? Is there anywhere else for investors to go?” And thus equity and fixed income investors are pondering and worrying instead of trading. Traders report that liquidity is very light, and dealers are struggling to handle both sides of the risk.

Mortgage REITs have seen their prices improve in 2011, and have been viewed as a powerful force in buying mortgage-backed securities. But their stock prices have come under pressure this week due to the potential downgrade of U.S. government debt. For example, two of the most prominent stocks in the group, American Capital Agency and Annaly Capital Management, fell as much as 2.5% on Monday alone. Perhaps this represents a good buying opportunity, especially with the dividends that some of them pay – around 19% in the case of AGNC. (They accomplish this through leveraging a strong balance sheet to buy a portfolio of government-sponsored housing agency paper on margin.)

But if Ginnie, Fannie, and Freddie securities are downgraded, their prices will drop and yields rise – not good for the REIT. It may find that it needs to put up more money to replace the value (like a margin call), and “collateral haircuts” have increased for U.S. Treasuries, agency paper and foreign sovereign debt.