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GSEs: how they rate. Moody's sizes up Fannie Mae's and Freddie Mac's creditworthiness.


Moody's sizes up Fannie Mae's and Freddie Mac's creditworthiness.

United States government-sponsored enterprises (GSEs) have gained prominence recently in the eyes of Washington policymakers and have now emerged as a major public policy issue.

This greater prominence reflects several factors, including the large and increasing number of GSEs active in the global debt markets, the huge portion of U.S. credit in the United States represented by the offerings of GSEs, and recent severe problems experienced by some GSEs here and abroad--such as those affected by the crisis experienced by FSLIC.

Investors--particularly overseas investors--have reacted to these events by eyeing GSEs with new skepticism. These investors are no longer satisfied to accept them on faith alone as top-quality credit without thorough analysis. The U.S. Treasury and General Accounting Office are also studying GSE finances and risks.

Taken as a whole, GSEs represent a significant portion of intermediated credit in the United States. Moody's estimates that Fannie Mae, Freddie Mac, the Federal Home Loan Banks, Financing Corporation (FICO), the Farm Credit System and Student Loan Marketing Association (Sallie Mae) have more than $660 billion in loans and more than three-quarters of a trillion dollars in gross debt. In recent years, GSEs have become more aggressive at selling their obligations to foreign investors, many of whom are less familiar with GSEs than their domestic counterparts. Moreover, several new GSEs have been established. Many of the new GSEs were created to assist other GSEs: FICO and Refcorp (Resolution Funding Corporation) were created to help provide funds needed by FSLIC to close insolvent thrifts, and the Farm Credit System Financial Assistance Corporation to help the Farm Credit System's banks.

Moody's rating approach to GSEs

Moody's has been rating the debt obligations of governments and of government-owned and related entities for many decades, and now rates will be assigned to well over 100 such entities around the world. In response to growing demand from investors--particularly foreign investors--Moody's has been assigning specific ratings to the debt obligations of United States GSEs, and now rates virtually all major GSEs that issue public debt not directly guaranteed by the U.S. government.

We begin with an analysis of the credit fundamentals of the GSE, taking each GSE on its own merits--without considering the potential for U.S. government support. This portion of the analysis is essentially the same rating approach Moody's uses for enterprises without any government connection. For example, for banking and finance entities, such as the Farm Credit System, Sallie Mae and the Federal Home Loan Banks, a CAMEL-type (capital, asset quality, management, earnings, liquidity) approach is used as a basis, layering in the operating environment, special characteristics of the enterprise, and other relevant credit matters, as appropriate.

In addition to these tools, Moody's analysis of Freddie Mac and Fannie Mae also uses tools used in mortgage insurance and financial guarantee company credit analysis. Moody's also examines the protections that any covenants in specific GSE bonds may provide investors.

The second major aspect of Moody's GSE rating approach is an assessment of the likelihood that the U.S. government will provide the support needed for timely payment of the GSE's debt, if required to prevent a default.

Some investors believe that the U.S. government's implicit guarantee towards a GSE, in and of itself, is as good as an explicit government guarantee of the GSE's debt. Moody's global experience in assessing government and government-related credit risk, however, forces us to be somewhat skeptical of accepting such assertions easily absent thorough research.

Some relatively recent examples show that government ties alone do not provide blanket assurance that debt will be given any government support.

Kongsberg Vaapenfabrikk, a large armaments and industrial concern wholly owned by the Norwegian government, failed in 1987, defaulting on about NKr. 1.6 billion in debt. The Norwegian government declined to support Kongsberg, asserting that, even though it owned the firm, it did not guarantee its debt and bore no responsibility to support its creditors.

A more recent example is DFC New Zealand, which failed in October 1989, defaulting on about NZ$ 2.2 billion in debt. DFC was created in 1964 by the New Zealand government to provide development funds and venture capital to New Zealand businesses. The government privatized DFC in November 1988, selling an 80 percent stake to National Provident Fund, the pension fund for the New Zealand civil service, and 20 percent to Salomon Inc., the U.S. securities firm.

The New Zealand government has refused to bail out DFC's creditors, stating that DFC is a private firm, and that the government bears no moral or other responsibility to DFC's creditors, even though it formerly owned DFC, and the bulk of the weak assets that prompted DFC's failure were booked during the period of government ownership.

Examples of government-related business failure and debt default also extend to the United States. The Federal Land Bank of Jackson, Mississippi, one of the banks in the Farm Credit System, became insolvent because of asset quality problems, and was placed in receivership in May 1988, defaulting on its trade creditors. The U.S. government has taken no steps to bail these creditors out.

These (and other) defaults demonstrate that government ownership or sponsorship does not necessarily translate into a strong credit standing for an enterprise. Because of this, Moody's closely reviews the particulars of the government relationship unique to each GSE. Factors that Moody's weighs include:

* A line of credit with the U.S.

Treasury--Should this line be drawn

prior to GSE failure (which is likely)

the U.S. government would

experience a direct loss, perhaps

increasing its desire to provide the

GSE assistance since its own

investment would be at stake. A Treasury

line of credit, in and of itself, can

also indicate an implicit guarantee

for a GSE. * Strength of U.S. government

control--To the extent the

government exercises greater executive or

regulatory control of a GSE, the

greater the potential that it will have

a stronger sense of obligation to

provide needed financial assistance. * Past GSE assistance--Prior

assistance can not only boost a GSE's

current financial health, but more

importantly can indicate that further

assistance would be forthcoming if

needed. * Explicit U. S. government

support--Sometimes the principal or

interest on GSE debt is explicitly

supported by the U.S. government.

In some cases, such as FICO and

Refcorp, (the principal amount of

the bonds has been de factor

defeased) with U.S. Treasury

zero-coupon bonds. * Economic, social and political

dislocations likely to come from the GSE's

failure--The more severe these

dislocations, the greater the likelihood

of U.S. government support. In

addition, these dislocations could

include foreign affairs to the extent

foreign central banks or other key

overseas investors hold securities of

the insolvent GSE, or to the extent a

GSE's failure would adversely affect

foreigners' willingness to hold

government or government-related

debt. * Stated political support--GSE debt

creditworthiness will be enhanced

to the degree that broad, stated

support is given by key political leaders

to GSE's creditors during times of

stress. * Powerful political constituencies--The

potential for federal support can

be enhanced by the presence of

powerful political constituencies that are

interested in the GSE's survival.

In making these judgments about the likelihood of adequate and timely U.S. government support of GSEs' creditors, Moody's draws on its extensive experience analyzing government-related credit risks globally, and on the resources of Moody's sovereign risk unit.

Once these assessments of the GSE's fundamental creditworthiness and of the likelihood of timely and adequate government support of the GSE's creditors have been made, Moody's arrives at a credit judgment, expressed in a credit rating, for the GSE's debt. Moody's ratings of GSE debt are identical to the ratings the company has used for over 80 years to rank the credit quality of all fixed-income securities worldwide. After a debt rating has been assigned, Moody's continues to monitor the GSE and the currency of the rating.

Freddie Mac

Moody's rates the long-term, senior, unsecured debt of Freddie Mac Aaa. Freddie Mac's "agency" status provides key credit rating support. The implicit guarantee of the U.S. government to assist Freddie Mac in a stress situation is reinforced by Freddie Mac's dominant position in U.S. housing finance. Added to that is the broad ownership of its securities by U.S. banks and thrifts and foreign central banks. Its mandate is to help increase the availability of housing capital which it fulfills by purchasing residential mortgages, packaging them into various mortgage participation certificates (PCs) (i.e. mortgage-backed securities), and guaranteeing the principal and interest on the securities. New capital requirements for banks and thrifts favorably treating securitized home loans versus unsecuritized mortgage assets is expected to increase mortgage-securitization volume, thereby enhancing the corporation's business activity.

Other relevant credit factors to weigh are Freddie Mac's well regarded management, acceptable levels of profitability, relatively adequate capitalization, and the potential for weakening asset quality.

Freddie Mac's returns are generally adequate, but sharpening competition and the commodity nature of many of its products are putting pressure on margins. Profitability, however, has held fairly stable for the last few years, but it is below earlier levels because of lower margins. Also, net charge-offs could rise because a large block of mortgages securitized during the refinancing boom of the mid-1980s is entering the higher default rate period. Multifamily mortgage quality also appears to be deteriorating, and the ultimate credit performance of adjustable rate mortgages (ARMs) is unclear.

Moody's believes that Freddie Mac is more or less adequately capitalized to endure a relatively broad range of fairly stressful operating environments. Equity and reserves relative to sold and retained mortgages have remained in a fairly narrow, low band for several years--except for 1986 and 1987, when the mortgage refinance boom caused a sharp jump in its PC guarantee business, boosting leverage.

Freddie Mac's current degree of leverage will probably continue for the foreseeable future. This judgment includes not only the likely future levels of reserves and retained earnings, but also the potential weakening of asset quality, as well as management's desire to maintain strong equity returns.

Credit losses have been low, a reflection of prudent underwriting standards and adequate credit-monitoring policies. Freddie Mac has controlled its credit risks (1) by enforcing prudent mortgage underwriting criteria, (2) by closely monitoring the servicing and credit quality of institutions that service mortgages for Freddie Mac, and (3) by requiring credit enhancements such as recourse, the substitution of current mortgages for foreclosed mortgages in securitized pools and private mortgage insurance.

Fannie Mae

Moody's rates the senior debt of Fannie Mae Aaa based on Fannie Mae's federal "agency" status and its important role in U.S. housing finance. The implicit guarantee of the U.S. government to assist Fannie Mae in a situation of financial difficulty is reinforced by Fannie Mae's dominant position in U.S. housing finance, historical legislative and regulatory support, as well as the ownership of its securities by a broad spectrum of foreign central banks and regulated domestic financial institutions.

There has been a rapid growth in Fannie Mae's volume of business, resulting in limited exposure seasoning and an increasing ARM component. The potential exists for adverse selection resulting from originator weakness and lower documentation standards. However, underwriting is conservative and uses sophisticated analytical formulas. A positive profit factor has been declining, marginal, administrative costs.

Fannie Mae's gross profit margins are now somewhat thin and reflect the wholesale, commodity nature of its intermediary funding activity, relatively low default risk associated with residential mortgages, and pricing that reflects the existence of first-loss, third party, risk-sharing. Overall profitability is improving.

Capital and reserves are more or less adequate to absorb losses under a relatively broad range of fairly stressful credit and interest rate scenarios. This judgment includes an assessment of management's sophisticated strategy to control interest rate risk, its underwriting strategy to lower default risk, strong future growth in business volume, likely sources of new capital, and longer term potential for weakening asset quality. We believe that the company has materially reduced its risk to interest rate changes, and on balance has also reduced the riskiness of its mortgage exposure. Higher capital requirements for banks and thrifts that favor securitized mortgage assets will increase mortgage sales and securitization volume, thereby significantly enhancing Fannie Mae's business activity. Once this source of demand stabilizes, we expect that the duopolistic competition with Freddie Mac and the commodity nature of Fannie Mae's products could put increased pressure on margins and/or on underwriting standards.

John J. Kriz is a vice president with Moody's Investors Service in New York.
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Title Annotation:government-sponsored enterprises, Moody's Investors Service; includes definition of GSE
Author:Kriz, John J.
Publication:Mortgage Banking
Date:May 1, 1990
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