FHFA Releases Results Of Fannie And Freddie Stress Tests

Posted by Patrick Barnard on April 30, 2014 No Comments
Categories : Residential Mortgage

If government-sponsored enterprises (GSEs) Fannie Mae and Freddie Mac were taken out of conservatorship and returned to the private market, would they withstand another major downturn in the economy?

According to stress tests recently conducted by the Federal Housing Finance Agency, maybe, maybe not, it depends on which test is applied and how severe the downturn is. When the FHFA applied its own stress test to the GSEs, both passed with flying colors – that is to say, the tests showed that the GSEs would not require an additional government bailout, even in a severe economic downturn.

But when the Dodd-Frank ‘Severely Adverse Scenario’ stress test (DFAST) was applied, it showed that the GSEs could require anywhere from $84 billion to $190 billion in government aid, depending on the treatment of deferred tax assets.

The difference, of course, lies in the parameters of the stress tests. As per the FHFA's report, ‘A number of assumptions contribute to higher losses in the DFAST Severely Adverse scenario compared to [the FHFA's worst case scenario]. First, the house price path in the DFAST Severely Adverse scenario is significantly more pessimistic than in [the FHFA's worst case scenario]. Furthermore, the decline in value of non-agency securities is substantially higher in the DFAST Severely Adverse scenario. In addition, the DFAST Severely Adverse scenario includes the effect of the default of a large counterparty, which the FHFA scenario does not include.’

Although the FHFA conducted two separate sets of tests – its own and the Dodd-Frank stress test – starting next year the Dodd-Frank stress test is the one that will apply.

The stress tests are similar to those conducted by the Federal Reserve to measure whether large banks and insurance companies have enough reserves to weather a severe economic crisis. Like the Federal Reserve, the FHFA cautions that the stress tests are ‘not expected outcomes.’

In fact, the stress tests have no basis in reality whatsoever when one considers that both GSEs, due to their conservatorship status, are currently prohibited from retaining cash reserves. Obviously, with no cash reserves in place, the firms would not be able to withstand any dramatic downturn in the economy, if they were made private again.

In its report, the FHFA provides a series of projections based on the severity of a potential downturn. For example, if home prices fell 4% this year before turning slightly upward next year, the GSEs would generate combined net income of $33 billion in 2014 and 2015. In other words, they could survive a mild recession.

But if home prices dropped 25% – a downturn worse than the one experienced in 2007 and 2008 – the companies could lose up to $90 billion, requiring up to $84 billion in government support.

As long as the GSEs remain in conservatorship, though, they are safe, as the both sets of stress tests show that the Treasury's existing bailout agreements will provide ample assistance to keep the firms solvent, even under a worst-case scenario. Fannie has $117.6 billion in potential support remaining from the Treasury while Freddie has $140.5 billion.

Meanwhile, Congress is mulling several GSE reform bills that propose eliminating Fannie and Freddie and replacing them with some type of a new governmet guarantor. Only one proposal – which is yet to be introduced – proposes returning the companies to the private sector largely intact.

The more popular bill – the Johnson-Crapo proposal – would eliminate the GSEs, replacing them with a new government insurer that would be responsible for backing loans sold onto the secondary market.

On Tuesday, the Senate Banking Committee delayed a vote on the Johnson-Crapo bill (based on last year's Corker-Warner proposal) in the hopes of getting more support for it in both the Senate and the House. However, GSE reform will likely end up being postponed altogether this year, as both parties await the results of mid-term elections, with Republicans hoping to gain a majority in the Senate.

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