Agency Loss Estimates Lack Independence, Verifiability
Jotham Sederstrom Nov. 1, 2011, 11:52 a.m.
More than three years into the conservatorship of Fannie Mae and Freddie Mac, moribund housing-market conditions remain a drag on households’ wealth trajectories and their confidence in the broader economic recovery. While a robust improvement in national price trends ultimately depends on job creation and endogenous demand for single-family homes, indications of a gradual stabilization of the housing-market trajectory are emerging.
As a function of updated housing-market expectations, as well as “actual results from the first of the projection period that were substantially better than projected,” the Federal Housing Finance Administration (F.H.F.A.) released a report last week updating its projections of potential agency draws from the Treasury under conservatorship. The upside adjustment to the projections should be considered in context, however, given limited transparency of the modeling process supporting the new estimates.
Some Better Housing-Market News
Earlier this month, the National Association of Homebuilders reported that its homebuilder confidence index jumped 18 points in September, the largest one-month increase since the short-lived improvements that coincided with the homebuyer tax credit. The overall increase reflects gains in current measures of home sales and homebuyer traffic and a larger rise in expectations of home sales six months from now.
The S.&P. Case-Shiller House Price Index was unchanged in the month of August, and 3.8 percent lower year-on-year, the best over-the-year reading since February. Similarly, the F.H.F.A. House Price Index was 0.1 percent lower in the month of August after posting modest increases in each of the previous four months, ending 4 percent lower year-on-year.
Existing home sales dipped in September, according to data from the National Association of Realtors released week before last. September sales were more than 10 percent higher than a year earlier but are also down by almost 10 percent from January’s high. The inventory of homes for sale has fallen more consistently than sales have picked up, but remains elevated by any historic norm.
New home sales rose 5.7 percent in September with gains in the two largest regions, the South and the West, offsetting a fall in the Midwest. At September’s sales pace, the supply of new homes on the market also tightened to 6.2 months, the lowest level since April 2010. However, house prices continued to fall in the Commerce Department report, with the median sales price for new homes down 3.1 percent in September and 10.4 percent year-on-year.
Implications for the Performance of Fannie Mae and Freddie Mac
In its report from last Thursday, the regulator and conservator of the enterprises updated its projections of Fannie Mae’s and Freddie Mac’s financial draws from the Treasury Department. As of this month, the enterprises have drawn $169 billion under the terms of the Senior Preferred Stock Purchase Agreements, including funds drawn to meet the program’s dividend obligations. In part as a reflection of the updated housing-market outlook and better-than-expected delinquency trends over the past year, the F.H.F.A. now projects that total draws will range between $220 billion and $311 billion by the end of 2014. Given the size of the draws, it is widely understood that the agencies cannot return to profitability as long as the dividend payments are enforced.
While expectations of smaller agency losses are welcome news, the broadsheets’ coverage of the F.H.F.A. update belies the need for scrutiny of the methodologies supporting the conclusions. In particular, the estimates are the result of modeling exercises undertaken by the agencies themselves, incorporating scenarios provided by the F.H.F.A. but using internal models. In light of the failure of the agencies’ risk-management processes during the housing boom, it is altogether unclear that the results of this exercise should be treated as valid. Given the broad implications for public policy and the U.S. taxpayer, the F.H.F.A.’s statement, that credit-related expenses were calculated using “a statistical loan transition model [that] projects the unpaid principal balance (U.P.B.) of loans expected to default over the projection period” as well as other modeling processes, may not pass the litmus test of model transparency. The F.H.F.A. is correct in pointing out that “the projections reported here are not expected outcomes.”
The issue is exacerbated by the F.H.F.A.’s use of house-price scenarios and other inputs from Moody’s. While the scenarios may be valid, the F.H.F.A. does not substantiate the criteria used to evaluate the efficacy or reliability of these projections or the sensitivity of results to alternative projections. Absent a more rigorous disclosure of modeling approaches and assumptions, it is impossible to determine if the tests employed by the agencies 1) capture the risks of individual mortgages or mortgage pools with any degree of accuracy or 2) are unbiased in their assessments of each enterprise’s whole residential mortgage portfolio.
Agencies’ Continuing Role in Financing Apartments
The F.H.F.A.’s assessments of agency health and the related cost to taxpayers matter for the future of housing finance and, by extension, for the apartment sector outlook, which is impacted by the direction of housing-finance reform efforts. The recovery’s cardinal markets, including New York, Washington, D.C., and San Francisco, have seen the agencies’ share of financing diminish as a wider range of lenders have responded to improving fundamentals. Still, a degree of crowding out—where nongovernmental lenders lose deals to preferentially priced agency financing—remains a factor limiting the balance-sheet gains of some banks and life companies. Some of these institutions have turned to financing apartment development as conditions demand greater risk-taking.
Outside of the cardinal markets, where apartment occupancy rates and rents are also generally rising, a range of regulatory and balance-sheet constraints on regional and community banks, combined with an unpredictable C.M.B.S. market that has seen little multifamily conduit activity, have resulted in agency financing’s maintaining its position as the dominant source of mortgages for sales and refinancing. That may remain the case for some time, even as housing-finance reform sees progress in refashioning the governmental role in the apartment sector.
Competition among lenders, and the very low cost of agency capital, has pushed debt yields to historic lows. Some market participants will cite relatively wider cap-rate spreads or positive leverage as mitigating factors in the risk analysis. But these arguments ignore that some recent deals would not be viable if interest rates were even 100 basis points higher. Invariably, cash-flow growth will have to remain strong and sustained to offset the impact of higher borrowing costs at exit. In markets or submarkets where the apartment-supply response is relatively sharp, that cash-flow growth is not assured even if the demand curve continues to shift out along its current trajectory.
Sam Chandan, Ph.D., is president and chief economist of Chandan Economics and an adjunct professor at the Wharton School.