In the next few years, the Treasury plans to completely wind down the Federal National Mortgage Association and the Federal Home Loan Mortgage Corp., and the impact on pre-refunded and escrowed-to-maturity municipal securities will be devastating.
Because of the government divestment, the collateral values of Fannie Mae and Freddie Mac bonds will drop significantly, and the municipal issuers of pre-refunded bonds will have the daunting task of meeting their contracts stipulating that the value of pre-refunded securities collateralized by Fannie and Freddie bonds must be sufficient enough to pay the principal and interest of the issue being refunded, on the original interest and maturity dates or on an early call date.
It is likely that many of these bonds will default, which would cause the municipal issuers' bond ratings to decline, and consequently negatively affect bond prices across the entire municipal securities bond market.
Even now, there is a wide spread between the prices of Fannie and Freddy bonds and Treasury bonds. Why is there not more publicity and action being taken on this inevitable market price bubble bursting? Because prior to the Treasury's plan to wind down the "reverse privatized" FNMA and FHLMC, it was, and still is, generally accepted by auditors and compliance professionals that these two corporations are in substance, explicitly government-backed.
Consequently, the generally accepted auditing principal of "substance over form" is why securities issued by Fannie and Freddie have been accepted as government-backed by the industry and investors.
This fallacy has evolved into a threat to the industry because there has been a concerted effort by the Obama administration and the Treasury to wind down the two mortgage giants, which essentially means to "privatize" them and withdraw U.S. government support.
President Obama has stated several times that the U.S. taxpayer will no longer support Wall Street corporations, and he has been recently joined by the junior senator from Massachusetts, Senate Banking Committee member Elizabeth Warren.
The federal government's efforts to wind down Fannie and Freddie began over four years ago.
On November 4, 2008, the U.S. Department of the Treasury stated in a press release that "one member recommended that Treasury should consider entering into a swap agreement with FNMA and FHLMC to enable them to grow their mortgage portfolio without the need to issue new debt under their name.
If the mandate for these GSE's — government sponsored enterprises — is to "grow for a short period" and then to "shrink," then it doesn't make sense for them to issue additional paper given the ambiguity of their future mission and the wide spreads to Treasuries that their bonds trade in the marketplace."
In 2011, the Obama administration reported that the government "will work with the Federal Housing Finance Agency to determine the best way to responsibly reduce Fannie Mae and Freddie Mac's role in the market and ultimately wind down both institutions, creating the conditions for private capital to play the predominant role in housing finance.
"These efforts must be undertaken at a deliberate pace, which takes into account the impact that these changes will have on borrowers and the housing market."
Further "implementing a wind-down of Fannie Mae and Freddie Mac's future participation in the housing market requires recognition of both the fragile state of that market today and the private sector's need for clarity about the speed with which that transition will take place. As the market begins to heal and private investors return, we will seek opportunities, wherever possible, to accelerate Fannie Mae and Freddie Mac's withdrawal."
In an Aug. 17, 2012, press release, the Treasury Department announced a set of modifications to the Preferred Stock Purchase Agreements, or PPSAs, between the Treasury and the FHFA as conservator of Fannie and Freddie that will help expedite the wind-down of the two GSEs, make sure that every dollar of earnings each one generates is used to benefit taxpayers, and support the continued flow of mortgage credit during a responsible transition to a reformed housing finance market.
"With today's announcement, we are taking the next step toward responsibly winding down Fannie Mae and Freddie Mac, while continuing to support the necessary process of repair and recovery in the housing market," said Michael Stegman, counselor to the secretary of the Treasury for housing finance policy.
"As we continue to work toward bi-partisan housing finance reform, we are committed to putting in place measures right now that support continued access to mortgage credit for American families, promote a responsible transition, and protect taxpayer interests," he said.
The modifications to the PSPAs are consistent with FHFA's strategic plan for the conservatorship of Fannie and Freddie that it released in February 2012.
The modifications include the following key components: "The agreements require an accelerated reduction of Fannie Mae and Freddie Mac's investment portfolios. Those portfolios will now be wound down at an annual rate of 15% — an increase from the 10% annual reduction required in the previous agreements. As a result of this change, the GSEs' investment portfolios must be reduced to the $250 billion target set in the previous agreements four years earlier than previously scheduled."
On Aug. 17, 2012, Reuters responded to this new action by publishing that "the U.S. Treasury on Friday revamped the bailout of Fannie Mae and Freddie Mac to curb chances the giant mortgage finance firms could emerge from government control as the powerful, profit-driven corporations they once were. The Treasury said it would require the companies, whose massive losses threatened the financial system after the housing bubble burst in 2007, to shrink their investment portfolios more quickly and turn over any profits to taxpayers."
It is because the Treasury is focusing on the housing market and its recovery that the nexus of Fannie- and Freddie-issued bonds to the municipal securities market has not been revealed.
James Hardaway Jr. is managing director at Integral Financial PC.