The Risks and Rewards of Fannie Mae and Freddie Mac Privatization

The privatization of Fannie Mae and Freddie Mac has reignited a decades-old debate about the role of government in housing finance. As the Trump administration and Treasury Secretary Scott Bessent push for reforms, investors, banks, and policymakers face a critical question: Can the U.S. mortgage market transition to a privatized model without triggering a surge in mortgage rates and destabilizing the broader economy? The answer hinges on the delicate balance between market discipline and systemic risk, particularly in a high-rate environment where housing affordability is already strained.

The Mortgage Rate Conundrum

The implicit government guarantee for Fannie and Freddie-backed mortgage-backed securities (MBS) has long been a cornerstone of the U.S. housing finance system. This guarantee allows the GSEs to borrow at near-Treasury rates, keeping mortgage rates low for millions of homeowners. However, analysts warn that privatization could erode this advantage. Pimco's Libby Cantrill argues that removing the implicit guarantee would force investors to demand higher yields to compensate for perceived risk, potentially increasing mortgage rates by 0.1–0.8 percentage points. At the upper end, this could add $600 annually to the average homebuyer's costs—a significant burden in a market where affordability is already at a record low.

The risk is amplified by the structure of the current system. Fannie and Freddie generate revenue through guarantee fees, which are kept low due to the government's implicit backing. Privatization would likely require higher fees to attract investors, directly translating to higher mortgage rates. Citigroup estimates that a 0.2-point increase in rates could reduce home purchase activity by 10–15%, exacerbating a housing market already grappling with inventory shortages and price inflation.

MBS Yields and Market Stability

The MBS market, which underpins half of U.S. mortgages, is another focal point of concern. The current fungibility of Fannie and Freddie securities—enabled by their shared government backing—creates a stable, liquid market. Privatization could disrupt this dynamic, leading to wider spreads and reduced liquidity. If the government fails to provide an explicit guarantee post-privatization, MBS yields could spike as investors demand higher returns for increased risk. This would not only raise borrowing costs but also create uncertainty for banks and institutional investors reliant on these securities for capital adequacy.

For fixed-income investors, the shift could be particularly jarring. Agency MBS are among the most liquid assets in the market, second only to U.S. Treasuries. A loss of government backing might drive capital into Ginnie Mae securities, which carry an explicit guarantee, but this would reduce the overall size and efficiency of the MBS market. Investors should monitor the spread between agency and Ginnie Mae MBS as a barometer of market confidence.

The Capital Conundrum

Privatization also faces a daunting capital hurdle. Fannie and Freddie are approximately $200 billion short of the capital required for a successful transition, even after retaining earnings since 2019. At their current combined earnings rate of $20–25 billion annually, it would take five to seven years to build the necessary reserves organically. An initial public offering (IPO) could accelerate this process, but raising $75–80 billion would be unprecedented and politically fraught. The Treasury's $340 billion stake in the GSEs further complicates matters, as any privatization plan would need to address how to handle this equity—whether through conversion to common shares, retention, or forgiveness.

Strategic Implications for Stakeholders

Fixed-Income Investors: The removal of the implicit guarantee would force a reevaluation of portfolio strategies. Defensive allocations to Ginnie Mae MBS or Treasury securities may become more attractive, while exposure to agency MBS could require hedging against spread widening. Investors should also consider the potential for a Fed policy shift if MBS are no longer deemed safe enough to be held on the central bank's balance sheet.

Banks: The 20% risk weight assigned to agency MBS under current regulations is critical for bank capital ratios. A loss of the government guarantee could reclassify these securities as riskier assets, forcing banks to sell holdings or raise capital. This could trigger a liquidity crunch, particularly for regional banks with large MBS portfolios.

Policymakers: The Federal Housing Finance Agency (FHFA) and Treasury face a difficult choice. Maintaining an explicit guarantee would preserve stability but risk perpetuating moral hazard. A hybrid model—where the government provides a limited backstop in exchange for stricter capital requirements—could mitigate risks while fostering market discipline.

The Case for an Explicit Guarantee

While privatization advocates argue that market forces would drive efficiency, the risks of a sudden withdrawal of government support are too great. An explicit guarantee, even at a cost, could prevent a spike in mortgage rates and maintain housing affordability. However, this approach must be paired with robust capital requirements and regulatory oversight to avoid the moral hazard pitfalls of the pre-2008 era.

Investment Advice

For investors, the key is to prepare for both scenarios. If privatization proceeds without a clear government backstop, consider increasing allocations to short-duration fixed-income assets and reducing exposure to long-term MBS. Conversely, if an explicit guarantee is established, agency MBS could regain their appeal as a low-risk, high-liquidity asset. Policymakers should prioritize a phased transition that allows the market to adjust while minimizing disruptions to affordability.

In conclusion, the privatization of Fannie and Freddie Mac is a high-stakes gamble with far-reaching implications. While the promise of a more efficient market is enticing, the risks of higher mortgage rates, market instability, and reduced affordability cannot be ignored. Investors must remain vigilant, hedging against volatility while monitoring policy developments that could reshape the housing finance landscape.