Why Fannie and Freddie may need more Treasury bailout cash

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Fannie Mae and Freddie Mac may be forced to take draws from the U.S. Treasury again, this time due to an accounting rules change for loan-loss reserves.

The Financial Accounting Standards Board is changing how financial institutions and investment companies determine their allowance for loan and lease losses. The existing "incurred loss" model lets companies build up a loss reserve over the life of a loan. But the new standard — known as Current Expected Credit Loss, or CECL — is an "expected loss" model, which requires companies to record a loss reserve at the time a loan is originated or acquired.

In other words, CECL changes the timing of when expected losses are recorded, but not the amount that's reserved, according to a recent Keefe, Bruyette & Woods research note.

Currently, Fannie Mae has an $18.6 billion reserve against its $2.9 trillion single-family guarantee portfolio, while Freddie Mac has $8.9 billion against a $1.8 trillion portfolio, KBW estimates. But those reserves are primarily set aside to cover risk on the government-sponsored enterprises' shrinking portfolio of precrisis loans.

Fannie and Freddie will need an additional $7.5 billion and $5 billion, respectively, to meet the new CECL requirements, KBW estimates. Companies aren't allowed to build up excess loan-loss reserves ahead of the Jan. 1, 2020, CECL deadline.

Fannie and Freddie should be able to tap into the $3 billion each in capital reserves they were allowed to build this year to cover a portion the CECL adjustment, but it won't be enough. And it's unclear whether the GSEs will have sufficient fourth-quarter 2019 profits to cover the difference. If either company doesn't, it will need a draw from the Treasury.

"It is hard to tell how likely it is. But based on our assumptions, [a draw] seems quite possible," the report's co-author, KBW Managing Director Bose George, said in an interview.

Federal Housing Finance Agency Director Mel Watt cited CECL as one of the reasons the GSEs would need a buffer to shield against short-term financial losses during October 2017 testimony before the House Financial Services Committee.

When asked if the regulator still had any concerns about the need for the GSEs to take a draw, an agency spokeswoman responded, "Implementation of the FASB standard, CECL, begins in 2020, and FHFA continues to monitor their implementation of this standard."

While Fannie and Freddie have remained generally profitable since early 2012, last year's tax reform legislation forced a number of companies, including the GSEs, to make accounting changes to their deferred assets. As a result, Fannie took a $3.7 billion draw from Treasury, while Freddie needed $312 million earlier this year.

According to Freddie Mac's 2017 year-end financial report, while it is "still evaluating the effect that the adoption of this Update will have on our financial results, it will increase (perhaps substantially) our provision for credit losses in the period of adoption. This Update increases the risk that we will need to request a draw from Treasury for the period of adoption."

Fannie Mae offered similar guidance in its first-quarter 2018 financial results.

"We will recognize the impact of the new guidance through a cumulative effect adjustment to retained earnings as of the beginning of the year of adoption," the company's report said. "We are continuing to evaluate the impact of this guidance on our condensed consolidated financial statements. We expect the greater impact of the guidance to relate to our accounting for credit losses for loans that are not individually impaired. The adoption of this guidance may decrease, perhaps substantially, our retained earnings and increase our allowance for loan losses," the filing said.

Earlier this year, the Federal Reserve proposed giving institutions three years to phase in the regulatory capital treatment of CECL to ease the upfront burdens of the change.

The Fed revision delays the "day-one" effects of CECL on regulatory capital ratios, Bart Everaert, market manager of risk and finance at Wolters Kluwer's finance, risk and reporting business, said in an email.

That way, "the regulatory capital ratios of banks would not be hit at once, potentially falling under the required levels, triggering punitive measures by the regulator," he said.

However, it does not "delay in any way" the required reserve amounts. "At the effective day of the CECL standard, a bank will need to account for sufficient credit loss allowances to cover its expected credit losses as computed using the CECL standard," Everaert added.

There are limited effects of CECL on other segments of the mortgage industry, according to George of KBW. Mortgage and title insurers are not affected at all because insurance contracts are not covered by CECL. Likewise, there should be minimal impact on nonbank mortgage lenders because they typically keep mortgages on their balance sheet as held-for-sale, which is not subject to CECL.

However, companies that hold mortgage servicing rights may need to be concerned with CECL compliance. That's because on defaulted loans, investor advances are treated as accounts receivables, which are covered by CECL, which may require an increase in reserves.

Most mortgage real estate investment trust hold mortgage-backed securities on their balance sheet at fair value, which also aren't covered by CECL. Other REITs, like Redwood Trust, do hold whole loans, but those are carried at fair value as well.