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Agency Debt Markets and the GSEs. Robert Rowe (212) 723-1168 Rohit Thapliyal (212) 723-1696. March 17, 2011. See Appendix A-1 for Analyst Certification and Important Disclosures

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Agency Debt Markets and the GSEs

Robert Rowe

(212) 723-1168

Rohit Thapliyal

(212) 723-1696

March 17, 2011

See Appendix A-1 for Analyst Certification and Important Disclosures

Citi Investment Research & Analysis is a division of Citigroup Global Markets Inc. (the "Firm"), which does and seeks to do business with companies covered in its research reports. As a result, investors should be aware that the Firm may have a conflict of interest that could affect the objectivity of this report. Investors should consider this report as only a single factor in making their investment decision.


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Digesting the Treasury White Paper on the GSEs

  • Largely in-line with expectations, Treasury laid out 3 options for structural reform

  • Positive market reaction in both agency MBS and agency debt

  • Treasury emphasized the role of rental housing and private capital in US housing

  • Unchanged level of support for the two entities:

    “Commitment to ensuring Fannie Mae and Freddie Mac have sufficient capital to honor any guarantees issued now or in the future and meet any of their debt obligations remains unchanged”

  • A slow transition does not expose taxpayers to incremental losses:

    “losses… all attributable to bad loans [Fannie and Freddie] took on during the heights of the housing bubble… new loans being guaranteed by Fannie Mae and Freddie Mac today are of much higher quality than in the past and are unlikely to pose a significant risk of loss to taxpayers”

Source: US Treasury, HUD and CIRA


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Treasury Short-Term vs. Long-Term Goals

Short-Term Implementable Goals

Long-Term Considerations

  • Access to mortgage credit

    • Gov’t support generally viewed as a positive (competitiveness, standardization)

  • Incentive for investment in housing

    • Seeking a balance. Government support makes housing investment more attractive, but can draw investment away from other sectors

  • Adequate Taxpayer Protection

    • Government pricing of risk can put taxpayer at risk due to political pressure to under-price

    • Requiring private capital take first loss should mitigate taxpayer risk

  • Financial and Economic Stability

    • Gov’t support promotes financial stability, but can encourage excessive risk taking in private market

  • Increase guarantee fees

    • To encourage private market competition

  • Increasing private capital ahead of guarantees

    • To reduce risk to GSEs

  • Reducing conforming loan limits

    • To scale back GSE share of the mortgage market

  • Reducing Investment Portfolios

    • To stop losses on portfolio which ultimately are passed to taxpayer

Source: US Treasury, HUD and CIRA


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Finally, the Treasury’s Proposal(s) for GSE Reform

  • Largest administration concern seemed to be excessive risk taking

  • General focus on access to mortgage credit, taxpayer protection, financial and economic stability

Option 1

Option 2

Option 3

  • FHA financing for low- and middle income borrowers

  • Private market finances vast majority of mortgage market

  • FHA financing for low- and middle income borrowers

  • Private market financing w/ gov’t backstop mechanism

  • FHA financing for low- and middle income borrowers

  • Private market financing, consistent gov’t reinsurance

Pro: Lowest-cost access to credit, reduced risk to taxpayer, economic stability

Con: Potential for degree of moral hazard

Pro: Soften credit contraction in crisis

Con: Uncertainty regarding efficacy of backstop

Pro: Reduction of moral hazard, low risk to taxpayer

Con: Limits access to credit

Source: US Treasury, HUD and CIRA


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Many Considerations to an Orderly Transition to Privatization

  • Securitization in the US (Capacity)

  • Regulatory reform: Dodd-Frank, Basel III

    • Impediment to bank balance sheet growth

    • Higher capital requirements

  • The State of Housing in US

    • Is home ownership in decline?

  • Treasury report moved the needle to privatization

    • Privatization may be a forgone conclusion, but what is the likely time and path?

  • Elections

  • Treasury feels there is adequate capital for Fannie Mae and Freddie Mac post December 2012.


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Non-Agency Securitization Has Witnessed a Heavy Decline Privatization

  • The decline in non-agency securitization production has never recovered from the financial crisis, as a result of bank de-leveraging and much stricter regulation and accounting policies.

Source: SIFMA

  • These outstanding balances are likely to decline further given higher overall guarantee fees, lower loan limits and higher credit standards.

Source: Citi


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Household Formation Slowed Sharply Below Trend in Recession Privatization

Annual Household Formation, 1989-2010

Average Household Size (Persons), 1991-4Q 10

Conservative projections anticipate near 14 million

new households for the 2010-20 decade.

Household data show “doubling up” but Homeland Security suggest larger role played by declining immigration from 2007 to 2009.

Source: Census Bureau.

Source: Census Bureau.


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Home Ownership Rates are in Decline Privatization

Source: Bloomberg


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Summary Privatization

  • Privatization of the Market May Be Likely

    • But the transition period will be long (despite Republican efforts to accelerate it)

      • Securitization markets have not recovered

      • Elections

      • Financial regulatory reform must still be clarified

      • Perhaps GSEs will continue to exist in a reduced form

    • Mortgage market is likely to shrink

      • Higher credit standards overall

      • Higher capital requirements

      • Will lead to lower home ownership

  • For Agency Debt Holders

    • Can take some comfort in the assurances of support from Treasury

    • Lack of debt supply will become an ever increasing challenge for high grade investors.



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Covered Bonds – Our Outlook Privatization

  • We expect the Covered Bond Act to become law in 2011

    • Two of the drivers behind the covered bond act (Rep. Bachus and Rep. Garrett) are now leading the House financial services agenda. They’re focused on GSE reform and see covered bonds as one element to privatize the housing market.

    • There is support for the bill on both sides of the aisle. The Treasury white paper on housing reform essentially endorsed a US covered bond market for large financial institutions.

    • The FDIC remains concerned about seniority of claims, among other things, and may represent the biggest impediment to legislation.

    • Senator Garret reintroduced the on 3/4/11. Recent hearing conducted on 3/11/11.

  • We estimate that the potential total size of the market will be modest: $400 billion.

    • The trajectory of spreads for this asset class may follow along the lines of the TLGP market given strong initial demand and a potential for strong spread returns.

    • $30 billion of foreign USD covered bonds was issued in 2010. The new issue market is typically well received with strong demand. Secondary liquidity has been poor though. The size of the market is essentially too small.

    • Issuance may be capped as a percentage of overall liabilities. The Treasury recommended a 4% cap as a percentage of overall liabilities in line with Canadian markets in regard to best practices in 2008.

    • Will provide the largest banks with additional funding flexibility.


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Covered Bonds: Preliminary Market Size Estimates Privatization

Potential Market Size

Potential FHLB Impact


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Concerns Privatization

  • How does the introduction of covered bonds affect the creditworthiness of senior unsecured debt?

    • Capping covered bonds as a percentage of total liabilities may assuage concerns but make for a smaller market.

    • $2 trillion dollar market estimates may be far fetched.

  • Is dual recourse really dual recourse if the bank’s level of non-performing assets increases in a systemic financial crisis?

    • Spread widening in European covered bonds is an example along with eventual government support.

    • Dynamic capital may not work.

  • How many regulators?

    • Current arguments in testimony lean towards one: The US Treasury. The FDIC may object to this.

  • While covered bonds clearly give large financial institutions great flexibility, will it be a preference over drawing advances with the FHLB or securitization?