Fannie, Freddie and FAS 166/167 (FNM; FRE)

From FT Alphaville:

Who would have thought a new accounting standard might end up increasing prepayment speeds on US mortgages?

The two US GSEs will be, like other US financial companies, adopting FAS 166/167 from 2010. The new rule is aimed at bringing off-balance sheet vehicles back on balance sheet — but it could end up having a rather interesting effect on US mortgages by way of Fannie and Freddie.

Here’s Deutsche Bank’s Arthur Frank to explain:

Under current Fannie and Freddie policies, a seriously delinquent loan must be bought out of an MBS pool at par plus accrued interest if any of the following three events occur: (1) the loan has been seriously delinquent for 24 months; (2) the loan has been permanently modified, whether through the Home Affordable Modification Program (HAMP), or otherwise; or (3) a foreclosure or short sale has been completed or the property deed has been conveyed by the borrower to the GSE. However, Fannie and Freddie have the right, but not the obligation, to purchase any loan out of their mortgage pools if the loan is at least 90 days delinquent, but until now the GSEs have generally chosen to leave such loans in their pools until one of events (1), (2), or (3) above have occurred.

The major reason that the GSEs have not bought out the large number of delinquent loans in MBS pools is a capital constraint; when a non-performing loan is bought out at par, it is immediately written down on the balance sheet to about 40% of face value, which is approximately the market bid side price for pools of seriously delinquent non-performing loans. The capital for this loss must be obtained from the Treasury Department, and such capital is expensive; the GSEs must pay a 10% dividend to the Treasury on such preferred stock. For the GSEs, buying out a 6.5% loan at par, then borrowing 60% of the face amount and paying 10% on the loan is not, of course, a profitable business model. So for the most part, the GSEs have chosen to leave such seriously delinquent loans in MBS pools and continue to pay investors the coupon month after month.

But those incentives will of course change come next year.

Both of the GSEs have concluded that they’ll have to consolidate the outstanding loans that they guarantee — about $4,500,bn according to DB — onto their balance sheets. Which means that suddenly buying out those delinquent loans won’t require additional Treasury-obtained capital...MORE