Risk Premiums to Rise

“I suspect we’ll start to see compensation start to rise for people who take credit risk,” Fannie’s executive vice president for capital markets, Peter Niculescu, said in a 45-minute speech and question-and-answer period at Lehman Brothers’ Mortgage and Specialty Finance Conference.

Fannie will be among the beneficiaries of this change because it will occur “not just in subprime but more broadly across the mortgage market,” he told attendees at the closed meeting, held in New York on December 11.

Because this change will “probably benefit us,” he said, it will “probably play a larger role than would otherwise be the case.”

The mortgage industry, including Fannie, Niculescu added, only can wait and “see how the future evolves and what happens.”

The coming rise in compensation is occurring as a result of the changes in the industry that are occurring now and could occur in the future, he explained.

“What would happen if there were a dislocation of subprime?” he asked. Then, noting that Fannie is “not really in subprime,” he said that “the question comes down to what would happen if there were a dislocation in the mortgage market more generally.

“Certainly you could see significant losses in subprime. You could certainly see a change conceivably in the processes that take those mortgages and that group of homeowners and intermediate them into the capital markets. You might see conceivably a change in what we do and how our business evolves as that occurs.

“Changes of that type,” he declared, “tend to change compensation for risk taking.”

Another change that could occur, and one that would directly impact both Fannie and Freddie Mac, involves foreign central bank investments in government sponsored enterprise debt and mortgage-backed securities, Niculescu cautioned.

“One of the larger variables that we face will be the behavior of non-U.S. central banks. There is some potential change there,” he said.

“Close to half of our mortgage debt and a significant portion of our [mortgage-backed securities] is going outside of the country” through foreign investments, he pointed out. And any changes in that allocation, he said, will affect the U.S. housing market.

“What we don’t know is whether they would change one asset class relative to the other,” he explained. “There are reasons to think they might but we don’t know how that will work.”

Demand for Freddie notes from institutional domestic investors continues to be strong, Niculescu said, but foreign investment in both notes and mortgage-backed securities has been growing so that “a fairly significant volume of what we do here is now going abroad.”

Flows from non-U.S. central banks into Fannie callable and noncallable notes have been “very significant,” starting in the 1990s and continuing to this day, he noted. And starting in 2000, Freddie Mac also began to see “very significant flows” into its MBS from four or five of the foreign central banks.

“Debt income is now going to be considerably more volatile over a three-four-five-year period,” Niculescu concluded. “It is likely to accumulate to a fairly meaningful result. We’re trying to handle this.”