U.S. MBS: Are Fannie and Freddie up for privatization?

The matter of privatizing Fannie Mae and Freddie Mac – two government sponsored entities (GSE) that buy mortgages and package them into mortgage-backed securities (MBS) – came into the spotlight recently when President Trump called for their release from government control.

The two companies have been under conservatorship since 2008, following a government bailout amid the collapse of the housing market.

Following President Trump’s comments, J.P. Morgan conducted a survey of MBS investors, revealing that nearly 70% of respondents expect privatization to happen within eight years, while just a quarter said they do not believe privatization will ever happen.

In our view, privatization of the GSEs is a complex issue with far-reaching financial, economic, and political implications. At the heart of the matter lie two key questions:

1. What would privatization cost, and who would pay for it?
2. How would the U.S. government handle guarantees on agency MBS?

We explore both questions in detail to help provide some perspective on the situation.

1. What would privatization cost, and who would pay for it?

When the U.S. government bailed out Fannie and Freddie in 2008, it effectively took a stake in the companies by way of a senior preferred stock purchase agreement (SPSPA).

In a nutshell, the SPSPA ensures that any retained increase in the value of the GSEs equates to an increase in the value of the U.S. taxpayer’s stake in the companies.

In 2019 and 2021, amendments were made to the SPSPA that allowed the GSEs to begin retaining capital. This was an important step toward potentially going private. However, the agreement also stipulated that as Fannie and Freddie’s capital reserves increase, so do the amounts owed to the U.S. Treasury to reimburse U.S. taxpayers.

Since the changes to the SPSPA, the combined net worth of Fannie and Freddie has increased from $23 billion in 2018 to nearly $147B in 2024.

At these valuations, we estimate the capital required to privatize the GSEs (including buffers) to be around $280B. At their current combined earnings rate of $20-25B per year, it would take five to seven years to organically grow their reserves to the levels required for privatization.

Instead of waiting until their reserves are built up, the GSEs could raise capital through an initial public offering (IPO). However, the required size would make an IPO very challenging. Even if the GSEs waited two years to issue an IPO, we believe they would need to raise approximately $75-80B of capital. That is 2.5 times more than the largest IPO ever (Saudi Aramco in 2019 at $29B) – a mammoth undertaking to say the least.

A second challenge is that even if the GSEs can raise the necessary capital, they cannot go private without first addressing the Treasury’s preferred stock position. According to Freddie Mac:

In accordance with the Senior Preferred Stock Purchase Agreement, until the senior preferred stock is repaid or redeemed in full, Freddie Mac may not, without the prior written consent of Treasury, redeem, purchase, retire or otherwise acquire any Freddie Mac equity securities (other than the senior preferred stock or warrant).

The current estimated value of the Treasury’s position is close to $340B, and the GSEs would require that this position be forgiven. In our view, forgiving $340B of value owed to the U.S. taxpayer would be politically fraught. So, while not impossible, we think privatization appears unlikely.

2. How would the U.S. government handle guarantees on MBS?

While equity investors may be most interested in the capital implications of privatization, investors in agency MBS are likely focused on the government guarantee, or backstop, on agency securities.

In our view, in the event the GSEs did privatize, an explicit government guarantee on MBS issued by Fannie and Freddie – which is how the market currently interprets backing – would be the simplest way to provide this backstop.

An explicit guarantee removes the need for investors to consider credit risk on MBS pools, allowing them to focus on duration and convexity characteristics. While this appears to be the easiest method, we believe it would be very difficult to push an explicit guarantee through Congress.

A second option would be to model the current implicit situation together with a funding commitment from the Treasury. Despite being more of a middle-ground approach, we think this option would also be difficult to push through Congress.

The final option would be to take the GSEs private with no government guarantee. In our view, this is the worst – and least likely – option, for the following reasons:

• The launch of the Uniform Mortgage-Backed Security (UMBS) in 2019 allowed pools of Fannie and Freddie mortgages to be commingled and delivered together. Privatization would result in legal and operational hurdles in the case of a credit event where the GSEs had to absorb losses. We think Fannie and Freddie would potentially need to merge to privatize – another significant hurdle.
• The loss of Fannie and Freddie’s status as government sponsored entities would likely result in sidelining certain buyers, such as banks (depending on their capital requirements), overseas accounts, and institutional buyers.
• There is also the question of whether the Federal Reserve would be allowed to own non-guaranteed MBS on its balance sheet.
• Absent any guarantee, we would expect a spike in 30-year mortgage rates, which would be politically damaging at a time when housing affordability is already very low.
• Liquidity issues may arise in to-be-announced securities during times of market stress, which would be damaging for both the housing market and the $10 trillion agency MBS market.
• Finally, without government backing, money managers would require a wider spread on Fannie and Freddie collateral when compared with the explicit guarantee on Ginnie Mae securities.

Conclusion

While an explicit guarantee is probably a political non-starter, a zero-guarantee scenario would likely be a non-starter for investors. Additionally, the capital requirements and questions around the Treasury’s senior preferred position present significant challenges to privatization.

Given the numerous challenges and complexities outlined above, we believe there is a very low probability that Fannie Mae and Freddie Mac will come out of conservatorship in the short to medium term, with little to no impact on MBS markets.

IMPORTANT INFORMATION

Derivatives can be more volatile and sensitive to economic or market changes than other investments, which could result in losses exceeding the original investment and magnified by leverage.

Fixed income securities are subject to interest rate, inflation, credit and default risk. The bond market is volatile. As interest rates rise, bond prices usually fall, and vice versa. The return of principal is not guaranteed, and prices may decline if an issuer fails to make timely payments or its credit strength weakens.

Mortgage-backed security (MBS): A security which is secured (or ‘backed’) by a collection of mortgages. Investors receive periodic payments derived from the underlying mortgages, similar to the coupon on bonds. Mortgage-backed securities may be more sensitive to interest rate changes. They are subject to ‘extension risk’, where borrowers extend the duration of their mortgages as interest rates rise, and ‘prepayment risk’, where borrowers pay off their mortgages earlier as interest rates fall. These risks may reduce returns.

Securitized products, such as mortgage-backed securities, are more sensitive to interest rate changes, have extension and prepayment risk, and are subject to more credit, valuation and liquidity risk than other fixed-income securities.