Fannie Mae and Freddie Mac, combined, could require a government bailout of nearly $126 billion in the event of a worst-case economic crisis, according to recent stress tests conducted by the agencies’ regulator.
The GSEs, under federal conservatorship since 2008, would still remain below caps set for U.S. Treasury draws under the worst-case scenario.
Despite the relative health of the entities — neither has made a Treasury draw since 2012 — other factors complicate their financial futures, including the fact that by January 2018 they’ll have no capital buffer to weather quarterly losses such as those experienced by Freddie Mac in the third quarter of last year.
It remains to be seen whether the latest stress tests will spark renewed calls for comprehensive housing finance reform but even if they do, it’s unlikely Congress will act until after a new administration takes office in January.
Annual stress tests for financial companies with more than $10 billion in assets — those primarily regulated by a federal agency — were implemented as part of the Dodd-Frank Wall Street Reform and Consumer Protection Act after the 2008 financial crisis.
The August test results on Fannie Mae and Freddie Mac mark the third time that the GSEs have undergone annual stress tests — “what if” scenarios to see whether they would be able to withstand a number of different economic scenarios.
As of Dec. 31, 2015, the GSEs have drawn a combined $187 billion from the U.S. Treasury under the terms of the Senior Preferred Stock Purchase Agreements (PSPAs) and there’s a remaining funding commitment of $258.1 billion.
Scenario assumes global shock and 10% unemployment
Under a “severely adverse” scenario, the GSEs are projected to need incremental draws from the Treasury that range between $49.2 billion and $125.8 billion, according to the stress test results. What would remain in the PSPA after the draws varies depending on the treatment of deferred tax assets.
The hypothetical “severely adverse” scenario assumed a global recession, severe corporate financial stress, and negative yields on short-term U.S. Treasurys.
Equity prices, under the scenario, would fall about 50 percent between December 2015 and the end of 2016, while equity market volatility would approach levels last seen in 2008. Home prices would crater by 25% through the first quarter of 2018 while commercial real estate prices would fare even worse, falling 30% through mid 2018.
Unemployment would double, from 5% to 10% by the third quarter of 2017.
The hypothetical scenario included a “global market shock” that would impact the GSEs’ retained portfolios, causing the failure of each GSE’s largest counterparty and resulting in an instantaneous and unrecoverable loss.
GSE financial cushion continues to decline
Because Fannie Mae and Freddie Mac are prohibited under their PSPAs from rebuilding their capital and are required to turn their profits over to the U.S. Treasury, their cushion to withstand a financial shock decreases with each passing year. Under the agreements, the two GSEs are supposed to have no retained capital by January 2018. That fact alone increases the GSEs’ financial vulnerability.
Calls for housing finance reform, which were strong in the wake of the financial crisis but which became muted over the past three years as the housing market has recovered, have begun to resurface, at least to some degree.
Still, it remains to be seen whether Congress or the nation’s presidential candidates will begin to take a renewed interest in housing finance reform.
This article was written exclusively for GoRion.