Fannie Mae and Freddie Mac’s common stock are currently overvalued, according to a report from Keefe, Bruyette & Woods. While the likelihood of privatization has risen, significant risks remain for investors at the current valuation for the government-sponsored enterprises.
The investment bank has dropped the ratings for both companies to “underperform,” but at the same time it has raised its price targets and earnings estimates.
Both companies’ common stock prices soared in the days prior to Pres. Trump’s second inauguration because the incoming administration was believed to be more amenable to releasing the government-sponsored enterprises. Freddie Mac hit a high of $7.15 per share on Jan. 15. That same day, Fannie Mae peaked at $7.80 per share.
But at 3:15 p.m. eastern time on Jan. 27, Fannie Mae was at $5.31 per share and Freddie Mac at $5.01. That level is still much higher than either company traded at before the 2024 elections, when both were in the $1 range.
That is also above KBW analyst Bose George’s new price targets for both companies. He raised his price target for Fannie Mae to $4 per share, up from $3, and for Freddie Mac to $4.50 from $4, “primarily due to incorporating a higher probability that the senior preferred shares are forgiven into our price target methodology.”
The senior preferred stock that the U.S. Treasury holds on account of the financial support provided as terms for the conservatorship are convertible into common shares. The liquidation preference for that stock has been increasing since both government-sponsored enterprises were able to retain their earnings (partially at first and currently 100%) in order to build net worth.
George boosted his estimate of the probability that those shares would be forgiven to 10% from 5%, but “our estimates still suggest that the risk/reward for the common shares is negatively skewed since we believe a failed attempt at GSE privatization or a successful privatization with dilution of senior preferred shares to common are higher-probability outcomes.” Investor Bill Ackman has proposed forgiving the preferred stock in his privatization plans.
Privatization does not necessarily mean that the implicit guarantee from the U.S. government for GSE securitizations would go away, in his view.
“The future of the implicit guarantee and its impact on the agency MBS market is arguably the primary issue that has to be addressed in order for GSE privatization to be successful,” George said. The implicit guarantee that was the common assumption prior to conservatorship became “more explicit” because of the government’s actions.
“We think a return to the pre-Great Financial Crisis implicit guarantee is possible, but only if Treasury messages this effectively,” George continued.
Almost half of MBS investors expect privatization by 2028, a J.P. Morgan Chase survey found.
The Mortgage Bankers Association is arguing that any release of the GSEs must include an explicit federal backstop for the MBS, including in a Jan. 16 video featuring President and CEO Bob Broeksmit.
The appropriate capital levels for the GSE is between 2.5% and 3%, KBW said, rather than the approximate 4.25% called for in the Enterprise Regulatory Capital Framework from the Federal Housing Finance Agency.
“We believe creating the right balance on GSE minimum capital is vital, as the capital level needs to ensure the safety and soundness of the companies while also allowing the companies to generate [returns on equity] that are high enough to attract external capital,” George said.
But Eric Hagen, an analyst with BTIG, said that the FHFA’s threshold appears adequate, especially because Fannie Mae’s historical net loss rate is just 30 basis points.
“Putting FHFA’s current capital requirement in perspective, we objectively think building capital above 4% of risk-weighted assets is rational and relatively sustainable, especially if the GSEs are consistently executing on credit risk transfer, although we don’t think investors will realistically buy into the idea of the capital framework serving as a ‘living will’ which replaces the need for an implicit or explicit guarantee during times of stress,” Hagen, who does not rate Fannie Mae or Freddie Mac, said in his residential mortgage finance note for Jan. 22.
“We don’t think FHFA will aim to meaningfully lower/adjust the capital ratio in order to accelerate a release from conservatorship, although we do think there could be room to offer more capital relief to the GSEs from executing CRT, including sharing more subordinate risk with investors,” Hagen said. “Even under most scenarios where the GSEs look capable of maintaining sufficient capital, we think investors treat the Enterprises as ‘too big to fail,’ and therefore relying on the capital framework in lieu of an implicit or explicit guarantee would still have the perverse effect of creating more volatility for MBS spreads and mortgage rates.”
George’s argument for the lower capital levels starts with the GSEs “effectively becoming insurance companies” who no longer manage interest rate risk in any meaningful way.
“The credit quality of the GSE single-family guaranty books has improved dramatically as well,” George said. “Finally, the level of reinsurance has also improved significantly, driven by the inception and growth of the credit risk transfer market post the GFC.”
