“We take virtually no credit risk.”

Anyone who has seen our presentation for Annaly Capital Management or one of our FIDAC-managed funds has heard us utter these words. Investors should consult our disclosure and offering documents for a complete list of the risks we DO take—including our principal risk, interest rate risk—but with all of the Fannie Mae and Freddie Mac headlines and housing bubble articles papering the market, it is worth revisiting this statement and the creditworthiness of a Fannie Mae or Freddie Mac mortgage-backed security. We’ll put our conclusion up top: Fannie Mae and Freddie Mac MBS are the premier asset-backed securities in the world, and we take virtually no credit risk when we invest in them. The rest of this paper explores why we are still comfortable making that statement.

First, some background: Fannie Mae and Freddie Mac are chartered by the US government to keep money flowing to the housing market. It is because of their relationship with the government that they are called government agencies or Government Sponsored Enterprises (GSEs). As Freddie Mac states on its website, it “purchases single-family and multifamily residential mortgages and mortgage-related securities, which it finances primarily by issuing mortgage pass-through securities and debt instruments in the capital markets. By doing so, we ultimately help homeowners and renters get lower housing costs and better access to home financing.” We and other secondary market investors buy those mortgage pass-through securities (which means our investors, in addition to receiving the spread income we generate, are also helping to finance the US housing market).

The accounting scandals at Freddie Mac in 2003 and Fannie Mae in 2004—generally arising out of earnings manipulation and faulty derivatives accounting—and the subsequent management shakeup, have given renewed life to the Washington-based effort for stronger regulation of the two companies. Treasury Secretary John Snow, Federal Reserve Chairman Alan Greenspan and members of both political parties have publicly aired their respective positions on the issue. Where all parties agree is that because all these scandals occurred on the watch of the current regulator, the Office of Federal Housing Enterprise Oversight (OFHEO), then the regulator must be changed. Where the parties differ is what this new oversight regime will look like, and what powers a new regulator should have.

As of this writing, the regulatory reform effort stands as follows: On May 25 the House Financial Services Committee approved H.R. 1461, the Federal Housing Finance Reform Act, by a bipartisan 65-5 vote. The bill proposes to create a new regulator called the Federal Housing Finance Agency, which would have the power to change capital standards, force asset sales, approve new lines of business and take over in the event of a financial crisis. The way the legislative process works, the Senate comes up with its own bill and the two bills would be reconciled during a “mark-up” process.

We have no special insight into the likely outcome of regulatory reform. The Administration has voiced its displeasure that the Baker-Oxley Bill does not contain explicit caps on the size of the balance sheets of the GSEs, and its strident opposition may prevent any bill from becoming law. On the other hand, this position may be nothing more than political posturing and the new regulator may look much like the one proposed by the House. Either way, the result will likely be friendly for creditors of the GSEs because it will not only shore up the safety and soundness of the institutions but give the government more power—and responsibility—to step up in the event of a financial crisis. The scandals and the legislative battle have also served another purpose—to focus attention on the most important aspects of the creditworthiness of the Agency MBS guaranty: the qualification of loans for inclusion in their mortgage pools and the GSEs’ credit risk management policies. What follows is a short examination of these features of Agency MBS.

The Guarantee

A mortgage-backed security that has been issued by Fannie Mae or Freddie Mac carries with it their guarantee that the investor in that security will receive the monthly payments of principal and interest in a timely manner, even if the homeowner is late with his or her payment. In addition, Fannie Mae and Freddie Mac guarantee that the investor receives the unpaid principal balance of a mortgage at its maturity or in the event of a refinancing or a default. To the investor like us, a default looks just like a refinancing. Thus, Fannie Mae and Freddie Mac are taking on the credit risk of the borrowers in their MBS pools.

What stands behind the Fannie Mae and Freddie Mac guarantee? The cover of every Fannie Mae and Freddie Mac MBS prospectus explicitly and unambiguously gives the answer to this question. Here’s the legend on the cover of every Fannie Mae MBS prospectus (emphasis theirs):

“We guarantee that the holders of the certificates will receive timely payments of interest and principal. We alone are responsible for making payments under our guaranty. The certificates and payments of principal and interest on the certificates are not guaranteed by the United States, and do not constitute a debt or obligation of the United States or any of its agencies or instrumentalities other than Fannie Mae.”

 And here is what Freddie Mac says (Freddie Mac calls their MBS Participation Certificates or PCs):

“We guarantee the payment of interest and principal on the PCs as described in this Offering Circular. We alone are responsible for making payments on our guarantee. Principal and interest payments on the PCs are not guaranteed by and are not debts or obligations of the United States or any federal agency or instrumentality other than Freddie Mac.”

It can’t get much clearer than that. However, as we all know, the financial markets have assumed that the US government implicitly backs this (as well as other senior unsecured) debt obligation of the GSEs—because of the special relationship they have with the government, because of their government charters, because of their central role in the vital housing finance industry, because they are just too big to fail. Take your pick, right or wrong, this is what investors believe. Not only that, this is a foundational rationale for the ratings agencies in assigning their triple-A ratings to the GSEs. (Note: The mortgage-backed securities are not rated, but the ratings agencies have rated the senior unsecured debentures of the GSEs triple-A. Because the GSEs’ guarantee on the MBS is a pari passu senior unsecured debt obligation, it has an implied triple-A.) For example, in its latest note on the GSEs, Fitch Ratings writes, “Senior debt ratings also include an assumption of support from the US government that would be provided in the event of severe financial stress.” Moody’s latest ratings release on Fannie Mae states that the company’s “Aaa-rated senior debt and Prime-1 rating for its short-term debt continue to be supported by the benefits associated with its GSE status, strong US Government-implied support, important public policy mission in housing finance, tremendous franchise value, and sound interest rate and credit risk management.”

Our risk is the risk that Fannie Mae and Freddie Mac, for whatever reason, could not make good on its guarantee (which, by the way, they have never failed to do and for which they have never needed the US government’s help). This is why we say we take “virtually” no credit risk. Inasmuch as the GSEs do hold a unique, and very sizable, position in the US housing markets and world financial markets, we also agree with the assessment of the ratings agencies and the market as it relates to the implied government backing. But how do Fannie and Freddie manage their credit risk? For that answer, you have to look beyond the ratings agencies and sheer faith to the mortgages themselves and to the Agencies’ own balance sheets. In other words, while it is important to ask what is behind the guarantee, it is just as important to ask what is in front of it. (Much of this discussion will center on data from Freddie Mac, which just released its 2004 Annual Report. Fannie Mae follows similar policies.)

Loan qualification

The mortgages backing mortgage-backed securities created by Fannie Mae and Freddie Mac conform to certain eligibility criteria, including loan size, initial loan-to-value ratio and credit quality of the borrower. As a result of the loan qualification process and Fannie and Freddie’s own credit risk management, their credit loss experience is very low.

Loan Size: Currently, the maximum original principal balance, referred to as the conforming loan limit, is generally $359,650 for single-family residential mortgages. Conforming loan limits may adjust annually. The conforming loan limits adjustments are based on the October-to-October changes in the average home price, as published by the Federal Housing Finance Board (FHFB). The FHFB figures come from its monthly survey of lenders. Both new and existing homes are included in the survey. This size limit tells us that the types of loans contained in Agency MBS are not “jumbo” loans. Furthermore, according to Freddie Mac, 94% of the homes in their total mortgage portfolio are properties occupied by the borrower as a primary residence, which tend to have lower credit risk than mortgages on investment properties.

Loan-to-Value: The initial loan-to-value ratio of a conforming loan can be no more than 80%, unless the borrower obtains mortgage insurance. This means that there is equity protection which grows as the principal value of the mortgage is amortized through the homeowner’s monthly mortgage payment obligations, provided that the underlying value of the property does not decline. Freddie Mac reports that at December 31, 2004, the weighted average loan-to-value of its single-family mortgage loan portfolio at origination was 70%, and that the current marked-to-market LTV of its portfolio is 57%. According to Freddie Mac, defaults are less likely to occur on mortgages with lower estimated current loan-to-value ratios, which in any event would have more equity to mitigate any credit losses. Thus a decline in the value of a home would have to exceed the amount of equity in the home before the foreclosure would result in a loss to Fannie Mae or Freddie Mac—on a portfolio-wide basis for Freddie Mac that would be a decline of approximately 43%. The loss amount would generally be the difference between the amount of the mortgage outstanding and the ultimate recovery sales price for the house. The graph below illustrates the trend in average LTV for Freddie Mac.

Underwriting criteria: The GSEs have established underwriting guidelines for mortgage loans they purchase that are designed to provide a comprehensive analysis of the characteristics of a borrower and a mortgage loan, including such factors as the borrower’s credit history, the purpose of the loan, the property value and the loan amount. This helps to ensure a high standard of credit quality in a Fannie Mae or Freddie Mac mortgage-backed security pool. Credit scores, which summarize a borrower’s credit history and form the basis for statistical models designed to predict the likelihood that a borrower will repay their mortgages, are used to qualify borrowers. The most commonly used credit scoring model, called FICO scores, is named after its developer Fair, Isaac and Co., Inc. FICO scores are ranked on a scale of 300 to 850, and borrowers with higher credit scores are more likely to repay their debts than those with lower scores. The weighted average credit score in Freddie Mac’s total mortgage portfolio was 723 at origination. The percentage of loans with FICO scores over 740 was 44%. (By contrast, a sub-prime borrower generally has a FICO score of less than 640.)

The end result of the credit work and qualification that is done by Fannie Mae and Freddie Mac is a loss experience that is very low. Net credit losses as a percentage of the outstanding mortgage credit book of business for Fannie Mae and Freddie Mac in 2003 were 0.006% and 0.007%, respectively. Below you will find a graph illustrating the credit loss experience of Freddie Mac compared to national banks.

Risk analysis

Applying strict underwriting criteria is just a way to minimize a bad credit outcome. It won’t prevent it. The fact remains that there will always be problems and the Agencies have to be sure that they will have enough capital to withstand any losses. For this they stress test their portfolios. Freddie Mac provides disclosure of its credit risk sensitivity analysis, which calculates the present value of portfolio losses over ten years as the result of an immediate decline of 5% in housing prices nationwide, followed by a more normal growth pattern of house prices. (As a point of context, a nationwide 5%-decline assumption is conservative, because national home prices haven’t even had a year-over-year decline, at least since 1950.) Freddie Mac estimates that at December 31, 2004, the net present value of the increase in credit losses in this scenario would be $794 million (before receipt of credit enhancements), or about 6.5 basis points on the total mortgage portfolio. To put that number in context, Freddie Mac’s equity at Dec. 31 was $31.4 billion.

Both Fannie Mae and Freddie Mac have to pass three different capital tests that have been established by the Federal Housing Enterprises Financial Safety and Soundness Act of 1992. The “critical capital” standard requires each GSE to hold core capital equal to 1.25% of on-balance sheet assets plus 0.25% of outstanding mortgages guaranteed by them. The “minimum capital” standard requires each GSE to hold core capital equal to 2.5% of on-balance sheet assets plus 0.45% of outstanding mortgages guaranteed by them. OFHEO currently requires each GSE to hold a surplus of at least 30% of its minimum capital requirement. The “risk-based capital” standard requires each GSE to hold core capital sufficient to absorb projected losses, plus 30%, in a test that simulates severe economic distress. The test is a 10-year simulation of two interest rate scenarios combined with adverse credit loss scenarios. The two interest rate scenarios are a) where rates rise by as much as 75% and b) where they fall by as much as 50%. The changes in both scenarios are generally capped at 600 basis points (6 percentage points). Included in the credit loss scenarios are shocks to house prices, credit default rates and loss severity rates. OFHEO’s test replicates the worst cumulative credit losses experienced by any region of the country that comprises at least 5% of the US population. In other words, OFHEO has identified the worst local bust in the country and applied those actual results to Fannie Mae’s and Freddie Mac’s entire portfolios. The benchmark region used in the risk-based capital test is from loans originated in Arkansas, Louisiana, Mississippi and Oklahoma (ALMO) during 1983-84. The ALMO region certainly experienced a housing bubble in the late 1970s and early 1980s inflationary oil-patch boom, and the bust that followed was significant. The house price path based on the ALMO experience and used in the stress test is a cumulative 13.8% decline in house prices over the first five years of the ten-year stress test (with prices gradually recovering over the second five years of the ten-year test). The credit default rate based on the ALMO experience is an average ten-year cumulative default rate of 14.9%. The average ten-year loss severity of ALMO over that period was 63.3%, which means that the loss rate for ALMO was 9.4% (default incidence times loss severity in the event of default).

Currently, both Fannie Mae and Freddie Mac pass their tests and are classified as “adequately capitalized”, the highest classification under these tests. In the event that Fannie Mae or Freddie Mac were “undercapitalized” (meaning they failed to meet the risk-based capital standard), or “significantly undercapitalized” (meaning they failed to meet the risk-based and minimum capital standards), OFHEO would restrict their ability to make capital distributions and take other actions. If either company were “critically undercapitalized” (meaning they failed all the capital tests), then OFHEO generally would be required to appoint a conservator for that company. Fannie Mae had been classified as “significantly undercapitalized” at December 31, 2004 based on adjustments to capital related to the accounting errors disclosed at the end of the year. However, as of March 31, 2005, Fannie Mae was able to reclaim the “adequately capitalized” standard through earnings retention, asset sales and capital raises, and it is on course to achieve its 30% capital surplus by September 30, 2005.

Conclusion

Investors in Agency MBS are protected by many levels of security: Besides the guarantee of Fannie Mae and Freddie Mac—and the loan qualification, risk analysis and balance sheet behind it—the MBS holder is protected and secured by the collateral of the mortgage-borrower’s home, the equity in the home, property/casualty and life insurance, the rights of foreclosure and the settlement process, and the reduction in the principal amount from monthly amortization.

The last word on this issue is the market’s: The market, confident in these multiple levels of security, have ignored the headlines. Throughout the last two years’ worth of GSE-related headlines, the mortgage-backed securities guaranteed by them have not been repriced by investors.

June 22, 2005
Jeremy Diamond
Executive Vice President
Annaly Mortgage Management/FIDAC

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This commentary is neither an offer to sell, nor a solicitation of an offer to buy, any securities of Annaly Capital Management, Inc. (“ Annaly”), FIDAC or any other company.

All information contained herein is obtained by Annaly from sources believed by it to be accurate and reliable. However, such information is presented “as is,” without warranty of any kind, and Annaly, in particular, makes no representation or warranty, express or implied, as to the accuracy, timeliness, or completeness of any such information or with regard to the results to be obtained from its use. While Annaly has attempted to make the information current at the time of its posting on the site, it may well be or become outdated, stale or otherwise subject to a variety of legal qualifications by the time you actually read it. ©2005 by Annaly Capital Management, Inc./FIDAC. All rights reserved. No part of this commentary may be reproduced in any form and/or any medium, without express written permission.