Can Fannie Mae and Freddie Mac Sustain Their Profits?

by 04 Apr 2013

A recent opinion piece by Matthew C. Klein and published by Bloomberg View argues that recent healthy profits posted by Fannie Mae and Freddie Mac could come to a stop once interest rates start to climb. Mr. Klein supports the reform of both government-sponsored entities (GSEs) even as they continue to post profits in the next few years. He argues that current profits at Fannie and Freddie may not last and could evaporate unless lawmakers and public officials agree on comprehensive reform.

Fannie and Freddie are enjoying the attention brought on by their record combined net profits in 2012, which totaled more than $28 billion. These record profits, which have continued in the first quarter of 2013, are the result of the thorough scrubbing performed on the mortgage investment portfolios of both GSEs over the last few years. Fannie and Freddie no longer have subprime mortgage debt in their portfolios, and they are profiting from current spreads between lending costs and the yield on the mortgages they guarantee. 

Today's cost of funding mortgages is kept reasonably low by the policies of the Federal Reserve Bank that aim to stimulate the economy of the United States. Mortgage interest rates are kept at low levels thanks to the Fed's third round of quantitative easing (QE3), which consists of purchasing mortgage-backed securities. Today's ultra-low rates entice banks to fund the home loans they originate with confidence.

Funding costs and yield spreads on mortgages are bound to rise in the future. This situation might create a loss situation for both Fannie and Freddie since mortgage lending activity is certain to diminish when rates go up. Scores of borrowers these days are taking advantage of low rates by refinancing their mortgages into home loans guaranteed by the GSEs; these borrowers are unlikely to refinance again when rates go up.

According to research conducted by the inspector general of the Federal Housing Finance Agency (FHFA), the GSEs are not prepared to deal with the upcoming rate spikes. The study suggests that Fannie and Freddie have hedges in place for slight changes in interest rates, but not for a protracted rise over a long period. 

The problem is that the GSEs are locked into long-term mortgage investment portfolios that perform well during periods of low interest rates, but not when rates go up. For this reason, Mr. Klein and others insist that reforming Fannie and Freddie is still a priority even though some lawmakers suggest that the GSEs should be left alone as long as they are profitable and repaying their debt to American taxpayers.

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