Fannie Mae Second Quarter 2019 Earnings Media Call Remarks
Hugh R. Frater: Good morning. We're pleased to present our second quarter results. They demonstrate the basic strength of our business model and our ability to generate solid returns.
Celeste is here to summarize our second quarter financial results and drivers. She will also cover the macroeconomic factors affecting our outlook and other key topics. And we will be glad to take any questions at the end of our remarks.
Before I turn it over to Celeste, I want to touch on a few accomplishments and some areas of focus.
We recently completed with FHFA and Freddie Mac the creation of the Uniform Mortgage Backed Security or UMBS, a project that took several years, and a lot of expense on our part. The hoped-for outcome of this significant transition – which has so far been smooth – is an even more liquid secondary market for mortgage securities. So far, the market is functioning well.
With much of the operational heavy lifting for UMBS behind us, we are focused on what's ahead.
Like many of you, we have watched with interest the evolving policy discussion about the future of the GSEs, including the possibility of ending the conservatorship. The Administration has put forth a number of principles for reform with the goal of ending the conservatorship.
We cannot predict the outcome of these plans, nor their timing. For our part, we continue to believe the best path forward for Fannie Mae is to continuously improve the strength and resiliency of our company, and to continue to deliver value, liquidity, and stability to the housing finance system.
Specifically, I want to highlight two areas of work this year that are vital to our long-term success as an enterprise and to the achievement of our mission. The first is our focus on capital management.
Fannie Mae is increasing its resources to support capital management in 2019, through the lens of the proposed capital framework under consideration by FHFA.
As we have said before, we believe that a robust and sensible capital regime for the GSEs is necessary, both to protect taxpayers in future housing downturns and to sustainably attract private capital to the housing finance system. We look forward to the completion of the capital framework currently under consideration by our regulator.
Ultimately, the framework will inform our approach to many aspects of our business, including how we achieve appropriate risk-adjusted returns on capital. How we deploy capital will be critical to our success at bringing more private capital into the system. We have put a great deal of work into capital planning with this goal in mind – and we will continue to do so.
The second area of focus this year – and for the foreseeable future – is enhancing the positive role Fannie Mae can have in the important issues facing the housing market and the communities our industry serves. We have always been a company with a mission and we are committed to being one in the future.
We are working in a few specific areas to help address the nationwide shortage of affordable housing. As a few examples,
- We continue to try to stimulate secondary market support for manufactured housing loans that are affordable to moderate- and low-income families.
- We're working with innovators across the housing industry to find new and less expensive ways to build, maintain, and finance homes for buyers and renters – and this includes ways to make housing greener, more resilient, and less costly to own and maintain.
These are important issues facing the housing market as a whole. They involve many stakeholders in the system and cannot be solved by the GSEs alone. Fannie Mae is working with many of those stakeholders to identify and enable new solutions to our country's housing challenges. And when those solutions begin to take shape, we will be ready to deliver liquidity and the housing finance tools necessary to support those solutions.
With that, let me turn it over to Celeste.
Celeste Mellet Brown: Thanks, Hugh, and good morning everyone.
First, I will review financial highlights for the quarter, and then move to our outlook. I will also touch on a number of things that impact our business.
In the second quarter of 2019, net income and comprehensive income were $3.4 billion, both up $1.0 billion compared to the first quarter.
Based on these results, we expect to pay a $3.4 billion dividend to Treasury by the end of September, leaving us with a net worth of $3.0 billion, which is the maximum capital buffer permitted under our agreement with Treasury.
The increase in profitability in the second quarter versus the first was driven primarily by higher credit-related income, net interest income, and investment gains during the quarter.
- Credit-related income in the second quarter rose primarily due to an increase in the redesignations of loans from held-for-investment to held-for-sale and a greater improvement in actual and forecasted home prices. To the extent that the population we are considering for redesignation declines, we would expect to see a reduced impact from this activity in the future. We have already substantially reduced the population of loans in our loss mitigation portfolio, which ended the quarter at $77 billion, compared to $84 billion at the end of the first quarter and $115 billion at the end of the second quarter of last year.
- The increase in net interest income was primarily due to higher amortization income from our guaranty book of business, driven by higher mortgage prepayment activity due to the declining interest rate environment.
- The increase in investment gains was driven primarily by the sale of approximately 38,000 reperforming loans with a total unpaid principal balance (UPB) of $6.1 billion, as well as the sale of private label securities. We did not sell any reperforming loans in the first quarter, and sold a smaller amount of private label securities in that quarter.
In our Single-Family business, our net income increased by $1 billion dollars in the second quarter vs. the first, driven largely by the same factors that drove our overall results.
Our market share of single-family mortgage loans securitized by the GSEs was 55% in the second quarter compared to 56% in the first quarter. Our market share has and will continue to fluctuate depending on many factors including product mix, market dynamics, mission requirements, and our returns on capital. We actively adjust our pricing strategy to address these factors and to achieve appropriate risk-adjusted returns.
Single-family acquisitions increased in the second quarter to $128 billion from $85 billion in first quarter, driven by an increase in volume due to continued lower rates in 2019 and by an increase in purchase activity due to seasonality. The average balance of our single-family conventional guaranty book of business remained relatively flat from the first quarter to the second, and increased by 97 basis points year-over-year to $2.9 trillion. Fluctuations in acquisition volumes in any one period have limited impact on the size and stability of our conventional guaranty book of business and the associated revenues and profitability.
The credit profile of our new acquisitions was positively impacted by the decline in rates and associated increase in refinance activity, as well as recent updates to Desktop Underwriter®, or DU®, our proprietary underwriting system. The refinance activity and DU changes drove a slight quarter-over-quarter decrease to our proportion of acquisitions with high weighted-average loan-to-value and debt-to-income ratios. These changes also drove a decrease in the proportion of our acquisitions with lower FICO scores as well as an overall increase in our weighted-average FICO scores. The overall improvement in our credit quality lowered our capital requirement for new acquisitions under the FHFA's proposed capital framework, or our acquisition capital rate, by approximately 8% quarter-over-quarter.
Average charged guaranty fees on our new single-family acquisitions, net of Temporary Payroll Tax Cut Continuation Act of 2011 (TCCA) fees, decreased by approximately 3 basis points to 47 basis points in the second quarter from approximately 50 basis points in the first quarter, and were 1 basis point lower than in the second quarter of 2018. The charged fee on acquisitions declined due to a competitive market environment and an improvement in the credit profile of new acquisitions, which thus require a lower guaranty fee to achieve our return requirements. The average charged guaranty fee, net of TCCA fees, on the single-family conventional guaranty book overall was approximately 43 basis points in the second quarter, a slight increase from the first quarter driven by the liquidation of loans with lower fees.
The single-family serious delinquency rate (SDQ) was 70 basis points at the end of the second quarter, down 4 basis points from the prior quarter and 27 basis points year-over-year. Our second quarter 2018 SDQ rate was elevated due to the impact of the 2017 hurricanes.
Turning to Multifamily, our net income of $561 million in the second quarter was similar to the first quarter. We continued to grow our average book, which was up more than 2% in the quarter and more than 11% year-over-year, driving an increase in guaranty fee income, which was offset by lower fair value gains in the quarter. While average guaranty fees on acquisitions have been stable over the past several quarters, they continued 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 73 basis points. The multifamily book remained strong from a credit perspective, as the severely delinquent rate decreased slightly to 5 basis points at the end of the second quarter, while the rate of substandard loans as a percentage of the book remained relatively flat quarter-over-quarter.
For Multifamily, our year-to-date market share of GSE mortgage acquisitions was 52%. As in the Single-Family space, we expect to see period-to-period fluctuations due to the same drivers: product mix, market dynamics, our mission requirements, and our focus on capital returns. Similar to the Single-Family space, acquisitions within a single quarter have a limited impact on the size, revenue, and profitability of the total multifamily book of business.
Turning to our economic outlook: Year-to-date GDP growth has been strong, and we expect some momentum to continue into the third quarter. However, our 2019 projection for GDP growth is 2.1%, compared to approximately 3% in 2018, and down from our prior 2019 expectation due to expected weakness in business fixed investment and softening global economic conditions. While we continue to expect consumer spending and labor productivity to support growth, we now believe weakness in fixed investment will weigh more heavily on the economy during the latter part of 2019 and through 2020.
Whereas interest rates increased through most of 2018, they declined in the first half of this year. The 30-year fixed mortgage rate at the end of June was 82 basis points lower than at the end of December. The Federal Reserve just cut the Fed Funds Rate by 25 basis points, and we anticipate that it will further reduce the rate by 25 basis points at its December meeting, to address continuing weakness in incoming inflation numbers.
Our proprietary Home Purchase Sentiment Index®, or the HPSI, reached a survey high for the year of 92 in May before dropping slightly in June. The decline in interest rates, as well as our survey indications that fewer consumers expect interest rates to increase again, 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 increased our home price growth forecast for the full-year 2019 to approximately 5%, up from our prior forecast of approximately 4%, as we see lower interest rates as more supportive of home price growth this year. Although the current housing supply and dearth of home construction continues to be a concern and an obstacle for affordability, we believe that recent mortgage rate decreases help to relieve some of the pressure on the affordability front.
Generally speaking, we expect a decline in interest rates to increase net interest income and credit-related income and drive fair value losses on a transitory basis. Mortgage loans tend to prepay faster in a declining rate environment, which results in higher net amortization income from cost basis adjustments on mortgage loans and related debt. Lower rates also shorten the expected lives of our modified loans, which reduces the impairment on these loans and results in a decrease in the provision for credit losses. Finally, when rates decrease, we tend to experience fair value losses primarily through our risk management derivatives and mortgage commitment derivatives. We expect that, once implemented, hedge accounting will partially mitigate these fair value movements, which can be either positive or negative depending on the rate environment.
We expect total single-family originations in 2019 to be above 2018 levels. Given mortgage rate declines, we continue to forecast year-over-year gains in refinance activity for each of the remaining quarters of this year, with overall refinance share of originations increasing from 29% in 2018 to 32% for full-year 2019. Refinance activity may also increase as a result of additional cuts to the Fed Funds rate or other factors.
The 2019 outlook for the multifamily sector remains positive, although supply could outpace demand in certain metro areas. Mortgage originations are expected to remain consistent with 2018. The U.S. multifamily vacancy rate tightened during second quarter and we expect it to remain below 6% through the remainder of the year, which is low compared with historical averages.
I wanted to give you an update on a few items that are top of mind for Fannie Mae right now.
We discussed last quarter that we would pursue changes to our credit risk transfer programs that may enable us not only to reduce earnings volatility, but also to optimize returns and capital levels in normal and stress scenarios. For our single-family Connecticut Avenue Securities®, or CAS deals, the company has extended the deal term of the transaction from 12.5 to 20 years, shortened the call option from 10 years to 7 years, and transferred a greater amount of the first loss position. Our first CAS offering with these new deal features in July was met with strong investor demand. On the Multifamily side, we are evaluating new forms of credit risk transfer, including potentially issuing a multifamily security similar to our single-family CAS securities.
We use credit risk transfer to reduce the amount of capital we would be required to hold under FHFA's proposed rule. For Single-Family, credit risk transfer and other credit enhancements reduced our capital requirement for credit risk on recently purchased eligible loans by more than 80%. The Multifamily business has been transferring a substantial and growing amount of the credit risk on acquisitions through both the DUS risk-sharing and back-end risk transfer programs. On last year's multifamily acquisitions, we transferred approximately half of the credit risk, and we expect to transfer an even greater amount of risk as we expand our back-end credit risk transfer program.
I'd like to touch on the Current Expected Credit Loss standard, or CECL. As we discussed last quarter, CECL is a new standard issued by FASB that we are required to implement by January 1, 2020. Fannie Mae is well-prepared for the operational transition. Upon implementation, we expect to recognize a cumulative adjustment to our retained earnings of up to $4 billion on an after-tax basis. In the event that this results in a net worth deficit, it would trigger a draw from Treasury in the first quarter of 2020. However, we are still assessing various implementation questions, which may reduce CECL's impact on adoption. In addition, there are many factors that could affect the likelihood of a draw, including our earnings over the next three quarters, the composition of our book, economic conditions, and forecasts at the time.
Implementation of the CECL standard will likely introduce volatility in our results as credit-related income or expense will include expected lifetime losses and thus become more sensitive to macroeconomic and other factors. This may drive additional volatility in our capital requirements under the Proposed Rule, due to the effect of changes in credit-related expense on our deferred tax assets.
Finally, I will turn to our continued focus on managing capital. As Hugh said, we view capital management as a core capability, with a long-term focus on generating appropriate returns on all of our products and services. While we are currently not permitted to retain more than $3 billion, we continually evaluate pricing and other aspects of the business to align with FHFA's proposed capital rule. In the second quarter, our capital requirement declined to $86 billion from approximately $87 billion at the end of the first quarter. The decline in required capital is primarily attributable to continuing increases in home prices, along with a reduction in the capital charge against our deferred tax asset.