GSEs Pass Hypothetical Economic Stress Tests
Written By: Joel Palmer, Op-Ed Writer
Fannie Mae and Freddie Mac seemingly passed their annual stress tests, with one independent analysis saying this year’s results demonstrates that the GSEs, combined, “have undergone a surprisingly large de-risking during their years in conservatorship.”
Last week, the Federal Housing Finance Agency (FHFA) released the results of the annual stress tests that Fannie Mae and Freddie Mac are required to conduct under the Dodd-Frank Wall Street Reform and Consumer Protection Act. The Dodd-Frank Act requires certain financial institutions with more than $250 billion in assets that are regulated by a federal financial regulatory agency to conduct annual stress tests to determine whether they can absorb losses as a result of severely adverse economic conditions.
The planning horizon for the implementation of the 2022 stress test is over a nine-quarter period from December 31, 2021 through March 31, 2024.
This year’s test scenario imagined a severe global recession that caused the GDP to drop more than 3.5 percent in the fourth quarter of 2021. In this hypothetical scenario, the economy continued to decline through the first quarter of 2023 before experiencing a “robust recovery.”
In this scenario, unemployment reached a high of 10 percent in the third quarter of 2023, while asset prices decline sharply as financial conditions in corporate and real estate lending markets become severely stressed.
Over the same time period, the spread between mortgage rates and the 10-year Treasury yield widened to 3 percentage points and then declines to just over 1.5 percentage points. In addition, equity prices fall by 55 percent through the fourth quarter of 2022, and equity market volatility increases substantially. Home prices decline by almost 29 percent while commercial real estate values drop 35 percent.
This year’s scenario also included a global market shock component that primarily affects the enterprises’ retained portfolios. This year’s global market shock is characterized by a sharp curtailment in global economic activity as financial conditions deteriorate and existing supply chain disruptions worsen. The FHFA report said that, compared to the 2021 DFAST cycle, this year’s hypothetical global market shock included more severe spread shocks affecting the enterprises’ agency mortgage-backed securities (MBS) and whole loans but slightly lower market value shocks affecting the enterprises’ private label securities (PLS) holdings.
Fannie and Freddie both stayed in the black during this hypothetical economic crash under the assumption that a valuation allowance on Deferred Tax Assets (DTA) was not established. FHFA attributed the positive results to portfolio growth and strong house price appreciation in 2021.
On the other hand, with the establishment of a valuation allowance on DTA, Fannie Mae suffered a comprehensive loss of more than $6 billion during the scenario period. Freddie remained profitable, with nearly $2 billion in comprehensive income.
The Furman Center, a housing research and policy center at New York University, has a comprehensive explanation of the DTA valuation results on a recent blog. It explained that guarantee fees are an important revenue source for the GSEs and are received upfront. Using GAAP accounting, these fees can be amortized over the life of the associated mortgage. But the taxes must be paid when the fees are received.
As a result, on a GAAP basis, the taxes paid up front are considered a pre-payment of taxes, creating a “deferred tax asset,” the center explained.
The Furman Center further explain that the FHFA, "instead of making a judgment about whether such a DTA write-down would or would not be required, has always reported the stress test results both on a without and a with DTA write-down basis.”
The purpose of the Furman Center article was to point out the extent to which Fannie Mae and Freddie Mac are assuming much less risk under conservatorship, which this year’s stress test compared with previous years demonstrates.
The authors note that the stress tests from 2013, the first year they were administered, showed almost $200 billion of loss for Fannie and Freddie. These losses reflected assets on the GSEs’ books that had been purchased before the mortgage bubble burst, kicking off the global financial crisis.
Since then, the modeled stress losses steadily declined to where they are now down to just $4.5 billion. While that may still sound like a big number, the report notes that it is only 0.06 percent of the $7.3 trillion of GSE assets.
The Furman Center concludes that the annual stress test improvements confirms: This very (1) a major improvement in the stability of the country’s entire financial system, and (2) a large reduction in taxpayer exposure to GSE risks.
FHFA noted in its report that the projections are not expected outcomes, but are only models in response to “what if” exercises based on assumptions about the GSEs’ current operations, loan performances and the hypothetical economic conditions.
About the Author
As an NAMU® Opinion Editorial Contributor, Joel Palmer is a freelance writer who spent 10 years as a business and financial reporter and another 10 years in marketing for the insurance and financial services industries. He regularly writes about the mortgage industry, as well as residential and commercial real estate, investments, and retirement income planning. He has also ghostwritten books on starting a business, marketing, and retirement income planning.
