FHFA stress tests reveal new vulnerabilities in U.S. housing market

Government-sponsored enterprises Fannie Mae and Freddie Mac, two of the largest investors in the U.S. mortgage market, would experience combined credit losses of $35 billion in the event of a severe financial downturn, according to a report from the Federal Housing Finance Agency released Thursday.

The annual Dodd-Frank Stress test, which examines how balance sheets of high-value federally regulated entities would be impacted in the event of a global recession, reflected a staggering increase in estimated losses from last year, when the same test initially projected they'd be more than $17 billion. (The 2022 stress test number for credit losses underwent a slight downward revision earlier this year after Fannie identified some errors in its model and adjusted for them, bringing that number slightly below $17 billion.)

While the credit losses in the stress tests, defined as net charge-offs plus foreclosed property expenses, were markedly higher than a year ago, the FHFA found Fannie and Freddie would generally be sufficiently capitalized to withstand the shock. Notwithstanding adjustments for allowances on deferred tax assets, both would generate positive comprehensive income under the stressed scenario.

That means Fannie has the capacity to absorb more than $21 billion in credit losses modeled while Freddie would be able to take on almost $14 billion. Under revised numbers for last year, Fannie would have taken on somewhere between $10 billion and $11 billion in credit losses in a stressed scenario, and Freddie would have taken on more than $6 billion.

However, Fannie's number for total comprehensive income after a severely adverse stress, at $6 billion, was about half of that seen in last year's revised numbers. Freddie's TCI, $4 billion, was around two-thirds of what it produced under the stresses modeled for 2022.

And with reserves set aside to offset potential losses on deferred tax assets, both enterprises would be in the red under the stressed scenario this year. Fannie would record a total comprehensive loss of $7.8 billion. Freddie would record a smaller loss of $600 million. Freddie remained profitable even with an allowance for deferred tax assets in place last year.

Provisions for credit losses remain the largest modeled expense at both enterprises. Mark-to-market losses became the second largest at Fannie. The impact of a global market shock with a counterparty default continued to be the second largest expense at Freddie.

The Dodd-Frank Act mandates that FHFA conducts annual stress tests for the enterprises in order to assess their capacity to withstand severe economic downturns. FHFA advises each government sponsored institution through the tests to ensure uniformity and comparability of results.

These tests — which the FHFA noted are not a forecast, but rather a tool to evaluate the enough capital to weather serious financial shocks — are now in their ninth iteration.

The most recent scenario — which had a testing "horizon" spanning nine quarters from December 2022 to March 2025 — simulates what could happen when economic downturns trigger distressed real estate markets, alongside challenges in corporate debt markets

Stresses modeled for that period included a decline in inflation-adjusted U.S. gross domestic product by nearly 8.75%, with a trough the first quarter of 2024 before recovering. The tests also looked at what would happen if unemployment soared by 6.5 percentage points and peaked at 10% in the third quarter of 2024. They additionally modeled an annualized consumer price index rate of inflation falling from below 3.25% to roughly 1.25% in the third quarter of 2023 before gradually rising to 1.5% by the end of the period.

Commercial real estate and home price declines of 40% and 38%, respectively, were applied to the financials of the two enterprises, up from 29% and 35% in last year's scenario.

Debt market developments the modeled scenario examined included the three-month Treasury rate reaching nearly zero by the third quarter of 2023. The model also had the 10-year yield falling nearly 3.25 percentage points by the second quarter of this year and exhibiting a gradual climb later in 2023 to around 1.5% by the end of the scenario's timeline.

The stress test outcomes provided an insight into the ongoing room for improvement at both Fannie Mae and Freddie Mac, who reported to Congress they ended 2022 critically undercapitalized under a different measure linked to conservatorship goals.

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