May 30, 2019
Washington says a major change in the mortgage-backed securities market could make home loans more affordable nationwide.
Not everyone on Wall Street is so sure.
The revamp, the most significant overhaul of the market in a generation, will virtually eliminate the distinction between bonds issued by Fannie Mae and Freddie Mac, which guarantee nearly half of U.S. residential mortgages. The hope is that blending the two will improve market liquidity and, as a result, mitigate investor risk while helping keep a lid on mortgage costs.
But skeptics warn that the change could actually raise mortgage rates, rather than lower them. The big test starts on June 3, when the first of a new breed of combined security is set to roll off the line. It’s the final step in a more than five-year process to unify a roughly $4.4 trillion pile of agency MBS currently split between the two government-sponsored enterprises.
“It already was the most liquid market in the world in many respects. What are they trying to fix, exactly?” said Walt Schmidt, head of mortgage strategies at FTN Financial in Chicago.
The success or failure of the overhaul will come down to whether MBS traders embrace uniform securities as the standard, or shun them, leaving one of the most important fixed-income markets in the world even more fractured than before.
The new rules allow market participants that are putting together mortgage bonds to deliver loans backed by either Fannie Mae, Freddie Mac or both when they settle trades in the to-be-announced (TBA) market. That’s the most liquid part of the MBS universe, in part because of established criteria under which mortgage pools are considered fungible and therefore don’t need to be specified at the time a trade is executed.
Second only to Treasuries in daily volume, trading in the TBA market dwarfs that of corporate bonds, municipal debt or other asset-backed securities. In fact, volume in 30-year Fannie Mae TBAs this year through April has averaged about $150 billion a day, the most since 2012.
|How an Agency Mortgage-Backed Security Is Built|
• A lender makes home loans with similar characteristics, and wants to
sell them to free up balance sheet so it can make more
• The originator brings the loans to a GSE, which securitizes and
• The GSE then sells the securitization to investors
• Or the mortgage lender may instead securitize and sell the loans itself,
using the GSE just for the guarantee
Because of Fannie Mae’s larger market share and different eligibility standards, trading in the mortgage bonds that it guarantees is dramatically higher than those of Freddie Mac. Since mid-2011, volume in Fannie Mae 15- and 30-year pools has consistently accounted for well over 80% of their combined total, according to data compiled by Oppenheimer & Co.
The relative lack of liquidity in Freddie Mac bonds has meant that they have traditionally traded at a discount to comparable Fannie Mae securities, and Freddie Mac has long paid a subsidy to mortgage originators to push for market share.
But by allowing both Fannie Mae and Freddie Mac TBA eligible pools to be delivered into the new uniform MBS, regulators at the Federal Housing Finance Agency say that the trading value disparity between the securities will decrease while the overall liquidity of the TBA market is enhanced. That will ultimately reduce investor risk and lead to lower mortgage rates.
“To some extent June 3 will be a bit analogous to Y2K, you don’t know if everything will be successful until after the fact,” said Jay Bacow, head of Morgan Stanley’s MBS research team. But “the mortgage market is second to Treasuries in terms of fixed-income liquidity and it’s challenging for us to see it losing that distinction under UMBS.”
Taxpayers should also benefit, the thinking goes, as Freddie Mac — under government conservatorship since the financial crisis — can funnel more of its profits to the Treasury without the need to offer lenders a subsidy.
Yet there are those who see a much more dire scenario lurking on the horizon. The initiative’s most vocal critics contend that it’s little more than a solution in search of a problem, and that regulator efforts may inadvertently raise borrowing costs for homebuyers rather than lower them.
Some market participants see a potential Achilles heel to the MBS revamp in the form of diverging prepayment speeds between Fannie Mae and Freddie Mac pools.
One of the main variables mortgage traders must accurately forecast to properly value their investment is the speed at which the underlying home loans will be paid off. Two securities with broadly similar characteristics, such as the same coupon, average credit score and maturity, may be valued at vastly different prices if the prepayment speeds on the underlying mortgages turn out to be dissimilar.
Should speeds diverge, investors may start to favor one GSE’s mortgages over the other and begin trading them separately again, resulting in a three-way split of the market among Fannie Mae, Freddie Mac and uniform securities — reducing overall liquidity in the process.
While there’s little sign that prepayment speeds are set to deviate in the near-term after years of low interest rates left most homeowners with little incentive to refinance, investors note that going forward even small discrepancies in the collateral profiles of Fannie Mae and Freddie Mac pools or distinctions in the behaviors of mortgage servicerscould fuel outsized differences in prepayments.
Others worry about a potential “race to the bottom” manifesting in the uniform MBS market, in which the GSEs begin to package loans exhibiting the most undesirable prepayment characteristics into the new securities as investors’ ability to price in speed differentials disappears. Such an outcome would see lower market prices — and higher borrowing rates — to reflect the deterioration in asset quality.
“If one agency is paying faster than the other, both will then price to the cheaper performer,” said FTN’s Schmidt. And “if both get faster in tandem, there’s no remedy for that situation.”
To prevent this, the FHFA is releasing quarterly prepayment monitoring reports, and has established so-called CPR bands that Fannie Mae and Freddie Mac pools must fall within to be considered in alignment.
|Conditional Prepayment Rates (CPR) Explained|
• The annualized percentage of the existing mortgage pool expected to
• Fannie Mae 4% 30-year conventional pools currently have a
three-month CPR of about 10.1%, close to Freddie Mac’s 10.3%
• Uniform MBS prepayment speeds will be considered misaligned by the FHFA if there’s a divergence in three-month CPR of greater than 2 percentage points between the GSEs
The FHFA can require the GSEs to adjust or terminate policies that are thought to be causing prepayment speeds to stray, and impose monetary fines for non-compliance. The ability of regulators to keep speeds in line is the linchpin to the success of uniform MBS, and many investors are confident that the FHFA’s efforts will be enough to prevent any divergence.
Others note that the overhaul has been well telegraphed, and traders have been getting ready for the changes for the better part of a year, boosting the likelihood of a smooth transition.
“There really shouldn’t be — in our view — any dramatic impacts unless there’s an imbalance due to liquidity,” said Neil Aggarwal, head of trading and deputy CIO at Semper Capital, which specializes in MBS and structured credit. “We’ve spent the last three to six months preparing for it operationally as well as understanding the components of pricing.”