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Edited Transcript of FNMA earnings conference call or presentation 31-Oct-19 12:00pm GMT

Q3 2019 Federal National Mortgage Association Earnings Call

Washington Nov 2, 2019 (Thomson StreetEvents) -- Edited Transcript of Federal National Mortgage Association earnings conference call or presentation Thursday, October 31, 2019 at 12:00:00pm GMT

TEXT version of Transcript

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Corporate Participants

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* Celeste Mellet Brown

Federal National Mortgage Association - Executive VP & CFO

* Hugh R. Frater

Federal National Mortgage Association - CEO & Director

* Pete Bakel

Federal National Mortgage Association - IR

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Conference Call Participants

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* Bonnie Sinnock

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Presentation

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Operator [1]

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Good day, and welcome to the Fannie Mae Third Quarter 2019 Results Call. Today's conference is being recorded. At this time, I'd like to turn it over to your host, Pete Bakel, Fannie Mae's Director of External Communications. Please go ahead, sir.

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Pete Bakel, Federal National Mortgage Association - IR [2]

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Thank you. Good morning, and thank you all for joining today's media call to discuss Fannie Mae's third quarter 2019 financial results.

Please note that this call may include forward-looking statements, including statements about the company's future financial results and financial condition, business plans and strategies, status, impact, capital requirements, economic and housing market forecasts, market share and dividend payments. Future events may turn out to be very different from these statements. The risk factors and forward-looking statements sections of the company's third quarter 2019 Form 10-Q filed today and its 2018 Form 10-K filed February 14, 2019, describe factors that may lead to different results.

As a reminder, this call may be recorded by Fannie Mae, and the recording may be posted on the company's website. We ask that you do not record this call for public broadcast and that you do not publish any full transcript.

I'd now like to turn the call over to Fannie Mae Chief Executive Officer, Hugh R. Frater; and Chief Financial Officer, Celeste Mellet Brown.

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Hugh R. Frater, Federal National Mortgage Association - CEO & Director [3]

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Thanks, Pete, and hi, everyone. This morning, we're pleased to present our third quarter financial results, which demonstrate the strength of Fannie Mae's business. Celeste Brown, our Chief Financial Officer, will summarize these results and the main drivers. Then, we'll be glad to take any questions you have.

Before I turn it over to Celeste, however, I want to touch on a couple of important and broader points. First, Treasury's Housing Reform Plan. We view the issuance of this plan as a positive development for the housing finance system, and it provides a road map for ending our now 11 years of conservatorship.

The main concepts in the plan have been in place for years, concepts such as clarifying the government's role in the secondary market, establishing appropriate capital standards, putting private capital at risk in front of taxpayers and potential regulation by a regulator with powers like those of bank regulators. Broadly speaking, the plan prioritizes what needs to be fixed and seeks to preserve what has been working.

Importantly, the plan envisions that GSEs will continue to execute their mission of providing liquidity to support housing to low and moderate-income Americans and that preserves the availability of the 30-year mortgage.

I think paying for government support and putting private capital at risk in front of taxpayers is the right approach. But we need to remember that having private capital requires delivering a return on that capital. Choices about the structure of the GSE business and what kinds of business are permitted would affect those returns. But I'm encouraged by the dialogue so far and the momentum, which brings me to point 2.

We are very pleased with the recent agreement with Treasury to increase the amount of capital we're permitted to retain from $3 billion to $25 billion. This means that we can retain our quarterly earnings until we meet that capital level, allowing us to begin restoring our capital base.

While much work remains to be done, I believe this represents an important step forward on the road to recapitalization and an eventual exit from conservatorship. I applaud Secretary Mnuchin and Director Calabria for taking this concrete action to move forward on reform. And the recently released FHFA strategic plan and scorecard specifically emphasize the need to prepare Fannie Mae for an exit from conservatorship, and we plan to be ready.

As policymakers continue to make choices about the future of housing finance, we will continue to take steps to prepare for an exit and a more competitive future. We welcome this future, and we believe long-term success for Fannie Mae will continue to mean 3 things: attracting and growing capital; providing a reasonable and sustainable return to the investors who entrust us with capital; and operating safely and soundly through business cycles, while performing our affordable housing mission.

Our mission is not just in our charter, it's in our DNA. As long as Fannie Mae is in the housing finance business, we will be in the business of affordable housing. We believe that providing liquidity for housing for low and moderate-income Americans is not only a great mission, but also a great business to be in.

With that, let me turn it over to Celeste.

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Celeste Mellet Brown, Federal National Mortgage Association - Executive VP & CFO [4]

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Thanks, Hugh, and good morning, everyone. In the third quarter of 2019, we earned comprehensive income of $4 billion, a quarter-over-quarter increase of more than $600 million.

As was announced during the quarter, and as Hugh just mentioned, the Treasury department and FHFA on our behalf agreed to increase the amount of capital we are permitted to retain from $3 billion to $25 billion. Accordingly, we can retain our quarterly earnings until we meet that $25 billion capital level, and we, therefore, did not pay a dividend in the quarter. As a result, our net worth reached $10.3 billion at the end of September. I'll discuss this agreement in more detail later in the call.

The increase in profitability in the third quarter versus the second was primarily driven by higher credit-related income and higher net revenues, partially offset by lower investment gains. Credit-related income in the third quarter rose primarily due to an enhancement to the company's allowance model to incorporate recent loan performance data for individually impaired single-family loans and better capture recent prepayment activity, defaults and loss severity data, which reflects the benefit of our active loss mitigation program. This model enhancement was performed as part of management's routine model performance review process.

Revenues increased slightly in the quarter. Guaranty fee income was up due to the growth of the guaranty book of business, which was largely offset by a decrease in income from the routine portfolio. This quarter, we also saw higher prepayment activity in both the single-family and multifamily spaces amidst the declining interest rate environment.

For single-family, this translated to higher amortization income, which runs through net interest income, along with other guaranty fee income. While in multifamily, it translated to higher yield maintenance fees, which affects fee and other income. Investment gains in the third quarter decreased compared to the second due to lower gains on sales of single-family loans and available-for-sale securities in the quarter.

As I mentioned previously, the company is working to implement hedge accounting, which is designed to reduce the earnings volatility related to the interest rate exposure. We experienced fair value losses in both the second and the third quarter. If our hedge accounting program had been in place during these quarters, these fair value losses would have been substantially lower.

In our single-family business, net income increased by approximately $450 million in the third quarter versus the second, driven largely by the enhancement to the company's allowance model that I described earlier. Our market share of single-family mortgage loans secured by the GSEs was 59% in the third quarter compared with 55% in the second quarter. Our market share has and will continue to fluctuate depending on many factors, including product mix, market dynamics, mission requirements and the need to meet our return hurdles. We actively adjust our pricing strategy to address these factors and to achieve appropriate results on business metrics.

Single-family acquisitions increased in the third quarter to $194 billion from $128 billion in the second quarter, driven by an increase in refinance volume due to continued lower rates in 2019 and by an increase in purchase activity due to seasonality. Acquisitions were up more than 50% versus the prior quarter and 60% versus the third quarter of 2018 and reached the highest level since the second quarter of 2013. The average balance of our single-family conventional guaranty book of business increased $17 billion compared with the prior quarter and $35 billion compared with the third quarter of 2018, reaching just over $2.9 trillion.

Our third quarter acquisitions represented under 7% of the total single-family conventional guaranty book of business. Given that the expected weighted average life of this book of business is around 5 years, quarterly fluctuations in acquisition volumes, market share, guaranty fee or acquisition credit characteristics in any one period have limited impact on the size and stability of our single-family conventional guaranty book of business and the associated revenue, profitability and credit quality.

The continued decline in interest rates and associated increase in refinance activity as well as updates to DU, our proprietary underwriting system, positively impacted the credit profile of new acquisitions. Refinance activity and DU changes drove a quarter-over-quarter decrease in the proportion of acquisitions with loan-to-value ratios over 90% and debt-to-income ratios over 45%. These changes also drove a decrease in the proportion of acquisitions with FICO credit scores below 680. The continued improvement in credit quality reduced our capital requirements for new acquisitions under the FHFA's proposed capital framework or acquisition capital rate by approximately 6% quarter-over-quarter. Our acquisition capital rate under the proposed rule has declined by approximately 9% since the current -- third quarter of 2018.

Average charge guaranty fees on our new single-family acquisitions, net of TCCA, decreased by approximately 1 basis point to approximately 46 basis points in the third quarter versus the prior and were nearly 4 basis points lower than in the third quarter of 2018. The decrease in fees was primarily driven by the overall higher credit quality of our acquisitions this quarter. Because of the steepness of the capital curve of the FHFA's proposed rule, we are able to charge less and still earn appropriate returns since we are acquiring higher credit quality loans with a lower capital rate.

The average charge guaranty fee, net of TCCA, on the single-family conventional guaranteed book overall was approximately 44 basis points in the third quarter, relatively flat versus the second. The single-family serious delinquency rate was 68 basis points at the end of the third quarter, down 2 basis points from the prior quarter and 14 basis points from the third quarter of 2018.

Turning to multifamily. Our net income of over $600 million increased by nearly $80 million versus the second quarter, primarily due to higher yield maintenance revenue as a result of higher prepayment volumes in the third quarter. We continue to grow our average book, which was up more than 2% in the quarter and 12% year-over-year. While average guaranty fees on acquisitions increased in the third quarter, they continue to be lower than those of our average multifamily book of business overall, which drove a slight reduction in our average book guaranty fee to approximately 72 basis points. The multifamily book remains strong from a credit perspective as the serious delinquent rate was 6 basis points at the end of the third quarter, up 1 basis point from the prior quarter, while the rate of substandard loans as a percentage of the book decreased approximately 30 basis points.

For multifamily, our year-to-date market share of GSE mortgage acquisitions was 46%. As in the single-family space, we expect to see fluctuations due to the same drivers: product mix, market dynamics, our mission requirements and our focus on capital returns. Multifamily acquisitions in the third quarter accounted for 5% of the total multifamily book of business. Given that the awaited -- the expected weighted average life of this book is around 5 years, acquisitions within a single quarter have a limited impact on size, revenue and profitability of the total multifamily book of business.

FHFA announced in September that the multifamily business for both GSEs will be subject to a new volume cap of $100 billion each for the 5-quarter period from October 1, 2019 through December 31, 2020, as compared to the former cap of $35 billion for 2019. The new cap does not have exceptions to what counts towards the limit. Further, at least 37.5% of each GSE's business during this 5-quarter period must be mission-driven affordable housing. We believe the new rules are achievable and will allow us to maintain our strong commitment to financing affordable housing.

Turning to our economic outlook. Year-to-date GDP growth has been relatively strong with the preliminary estimate of the third quarter growth for 2019 at 1.9%. We expect continued growth into the fourth quarter, with a full year GDP growth projection of 2.2%, slightly down from 2.5% in 2018.

We do see downside risk due to global trade tensions and weak manufacturing data, which we expect to weigh more heavily on the economy in 2020. Throughout October, the 30-year fixed-rate mortgage has remained a full percentage point below a year-ago levels. The Fed cut the Fed funds rate by 25 basis points in July, September and again yesterday, and we anticipate that this will further reduce the rate by 20 -- and anticipate that they will further reduce the rate by 25 basis points in the first quarter of 2020 before pausing for the remainder of the year.

The housing sector showed renewed strength in the third quarter, with improvements in home sales, home construction and construction spending. In addition, our home prices -- purchase sentiment index, or HPSI, reached an all-time survey high of 94 in August before dropping slightly in September. The net share of survey respondents who believe that it is a good time to buy or sell a home is up year-over-year, but uncertainty about the economy and individual financial circumstances appear to be weighing on housing market attitude.

The continued decline in interest rates as well as our survey indications that fewer consumers expect interest rates to increase in the next 12 months generally supports housing market demand. However, we also see continued pressure on supply, particularly a lack of affordable inventory, limiting growth in home sales.

We have reduced our home price forecast for the full year 2019 to 4.8%, down from 5.5% in 2018, due to incoming actual data. The decline in interest rates has not boosted home prices as expected. The weak reaction of home price growth to lower interest rates could be a sign that we have reached affordability limits in some markets.

We continue to expect total single-family originations in 2019 to be above 2018 levels, with purchase mortgage originations remaining relatively flat and volume growth driven by higher refinance activity due to mortgage rate declines. National multifamily market fundamentals, which include factors such as vacancy rates and rents, remained steady during the third quarter of 2019, most likely due to ongoing job growth, favorable demographic trends and renter household formation. Based on preliminary third-party data, we estimate that the national multifamily vacancy rate for institutional investment-type apartment properties remained at 5.3% as of the end of the quarter, and that effective rents increased during the third quarter. Several years of improvement in fundamentals has helped to increase property values in most metropolitan areas. Although multifamily fundamentals remain positive, we believe increasing supply will result in a slowdown in effective rents for the remainder of 2019 compared with recent years.

As I mentioned earlier in the call, the Treasury department has modified the terms of the senior preferred stock, permitting us to retain up to $25 billion. We are not required to pay dividends to Treasury until we exceed this level. As we increase our capital reserves, the likelihood of a future draw from Treasury is reduced. The recent agreement with Treasury also provides that quarterly increases in our net worth will be matched by increases in Treasury senior preferred stock liquidation preference of up to $22 billion.

As we've mentioned this year, CECL is a new standard issued by FASB that we are required to implement by January 1, 2020. Fannie Mae continues to be well prepared for the operational transition. Upon implementation, we expect to recognize a cumulative adjustment to our retained earnings of up to $2 billion on an after-tax basis, which will be reflected in our first quarter 2020 results and which we expect to absorb through earnings and/or retained capital. We have refined our estimate impact upon CECL adoption over the last quarter will incorporate updated economic conditions and the resolution of various implementation items.

Credit risk transfer and other credit enhancements have reduced our capital requirement for credit risk on the recently purchased eligible loans by more than 80% for single-family and more than 50% for multifamily through the third quarter. Additionally, we have been evaluating loan populations not historically eligible for single-family credit risk transfer, including loans made under our Refi Plus program and the Home Affordable Refinance Program, or HARP. We have also expanded our back-end credit risk transfer activities on the multifamily side with our multifamily Connecticut Avenue Securities deal in October as well as the settlement of our second multifamily credit insurance risk transfer deal of the year in September.

In addition to credit risk transfer transactions, the multifamily continues to utilize the delegated underwriting servicing program to share a substantial amount of credit risk on our acquisitions. At the end of the third quarter, the amount of capital we would be required to hold under the FHFA's proposed capital rule was approximately $86 billion, consistent with the second quarter. The impact of higher acquisition volumes during the quarter, which increased our capital requirement, was offset by a larger capital reduction benefit from credit risk transfer and other credit enhancements as well as a reduction in the capital requirements for the retained portfolio due to sales of reperforming and nonperforming loans during the quarter.

With that, I will turn it over to the operator, and Hugh and I will answer your questions.

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Questions and Answers

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Operator [1]

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(Operator Instructions) And we'll take our first question from Bonnie Sinnock with SourceMedia.

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Bonnie Sinnock, [2]

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I wondered if you could tell me -- I think you've mentioned this before, but I wanted to double check. The driver for the reduced purchases of the high LTV and higher DTI loans, what was the catalyst for that?

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Celeste Mellet Brown, Federal National Mortgage Association - Executive VP & CFO [3]

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There were a few catalysts or core drivers for that. First, as is typical in a refinance market, credits -- the credit looks slightly different. You typically could see lower LTV loans, lower DTI loans. In addition, we have been making adjustments to DU, our underwriting system for single-family, to limit the layering of multiple risk factors, and that has reduced the overall volume of those loans.

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Bonnie Sinnock, [4]

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So it sounds like that has a side effect of helping with the capital requirements, but that wasn't the original catalyst for those changes.

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Celeste Mellet Brown, Federal National Mortgage Association - Executive VP & CFO [5]

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The original driver of those changes is that we actively monitor the risk of the book as a whole. And last year, as rates were rising, the mix of loans coming in versus the changes that we have made to these previously was -- made us stop and question the risk layering, and we took action to ensure that we were comfortable with the risk and the direction that it was headed.

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Operator [6]

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And it looks like we have no further questions in the queue. So I'd like to turn it back over to our speakers for any additional remarks.

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Hugh R. Frater, Federal National Mortgage Association - CEO & Director [7]

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Hi, everybody. This is Hugh. Thanks a lot for joining the call. And I would be remiss if I didn't add one more important message for all of you, which is go Nationals. Thanks for coming.

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Operator [8]

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And that does conclude today's conference. Thank you, everyone, again for the participation.