The Federal Housing Finance Agency (FHFA) – the entity that overseesmortgage giants Fannie Mae and Freddie Mac, which are currently in federalconservatorship and collectively constitute 71% of the mortgage market1 – recently completed a roadshow on its “Single Security” proposal, whichwould represent a significant change to the current mortgage market.
While we appreciate the primary goals of the FHFA proposal – increasedliquidity and reduced costs to taxpayers – we have serious concerns aboutthe proposal as is and worry that without significantmodifications, it could actually lead to reduced liquidity, andmore importantly, to higher mortgage rates for those purchasing ahome and for those homeowners needing to refinance.
Given these reservations, we welcomed the recent FHFA announcement that itintends to delay the rollout of the Single Security to 2019. Not onlyshould this additional time provide FHFA the opportunity to address some ofthe structural issues associated with the current proposal (outlinedbelow), it hopefully will provide Congress the needed time to make progresson housing finance reform – a critical step, in our view, before the FHFAmoves forward with the Single Security plan.
What is the Single Security proposal, and why is it being proposed?
Currently, Fannie Mae and Freddie Mac (“Fannie,” “Freddie,” or collectivelythe “agencies”) separately issue and guarantee mortgage-backed securitiesthat are backed by pools of residential mortgage loans. For a variety ofreasons, including historically faster prepayment speeds and reduced marketliquidity, Freddie Mac securities consistently trade at a discounted price(and at higher rates) to those issued by Fannie Mae. Consequently, in orderto induce mortgage originators to do business with Freddie Mac, the companyhas had to subsidize mortgage originators – called a “mortgage adjustedprice” or “MAP.” Indeed, Freddie has spent hundreds of millions annually(billions cumulatively) on this subsidy, which has led to reduced profitsto Freddie, and ultimately less money to the Treasury Department (sinceFreddie and Fannie currently sweep profits to Treasury under the 2010 StockPurchase Agreement).
The Single Security proposal seeks to eliminate price differences betweenFannie and Freddie’s securities, and therefore eliminate the need forFreddie to subsidize originators. This would be accomplished by creating aunified mortgage-backed security: New Fannie or Freddie securities would beissued under a Single Security structure, and existing Fannie and Freddiesecurities could be converted into the new structure. FHFA asserts thatthis Single Security would reduce costs while also increasing mortgagemarket liquidity by unifying the two markets.
What could go wrong?
To be sure, this plan sounds appealing. However, as a long-time, largebuyer of agency mortgage-backed securities, we have several concerns withthe current proposal:
- A race to the bottom?Today, Fannie Mae and Freddie Mac compete with one another on thequality of the mortgage-backed securities they issue. If Freddieissues securities backed by mortgage loans with less appealingcharacteristics for investors (e.g., credit quality, prepaymentcharacteristics), the market will punish Freddie by demanding adiscount on the price of those securities and viceversa. Under theSingle Security proposal, this ability of investors to policeFannie and Freddie and differentiate on price to ensure each entityis delivering the best product to the marketplace would be lost.Without the market as the enforcer, Fannie and Freddie would losetheir incentive to compete on the quality of their product, whichcould lead to a “race to the bottom.”This would likely lead to a lower quality security forinvestors.While FHFA has asserted that there will be “alignment” between thesecurities issued by Fannie and Freddie under the new SingleSecurity structure, FHFA does not have any existing mechanism toenforce this under the current proposal.
- Perversely, markets could become less liquid, leadingto higher mortgage rates. One of the primary objectives behind the Single Security proposalis to improve liquidity in the mortgage market, but we have twoconcerns regarding this premise. First, the mortgage market is oneof the most liquid, well-functioning markets worldwide, so theproposal is solving for a market problem that, in our view, doesnot exist. Second, liquidity would only improve from itsalready-strong levels if holders of legacy Fannie and Freddiesecurities choose to “convert” into the new Single Security. Theproblem is that there is no incentive to convert, as holders oflegacy securities would be charged a fee for doing so under thecurrent proposal.
Practically, if investors do not convert, the market couldultimately become trifurcated with smaller floats in each segment:legacy Fannie Mae, legacy Freddie Mac and a new Single Securitymarket. This is similar to the experience in 1990, when Freddie Macintroduced a new security (Freddie “Golds”), which should have beenpreferred by investors. But they chose not to convert, leading tomarket fragmentation and reduced liquidity for decades.
- Dual guarantee could cause confusion during times of stress.Under the proposal, during times of stress, there may be confusionsurrounding which agency is the ultimate guarantor of the newsecurity if the issuer is different from the one that packaged theloans (e.g., Fannie is the new issuer but the underlying collateralloans are packaged by Freddie). We worry that it is unrealisticthat Fannie and Freddie, which are legally separate entities, willunconditionally promise to guarantee the other’s loans withouthaving evaluated the underlying collateral. We think this could beaddressed with explicit contractual language, but investors need tobe able to review this language well in advance.
If the proposal moves forward, we recommend the following:
- Conversion must be free.As mentioned above, the only way that the Single Security will beable to deliver on its promise to increase market liquidity is ifthere is widespread conversion to the new Single Security. Underthe existing proposal, there would be a cost to conversion, whichwe think will dissuade existing holders of agency bonds fromconverting, leading to a more fragmented market and likely highermortgage rates. In order to avoid this, we believe FHFA should notonly abolish the proposed fee, but instead offer an incentive to investors who convert within a distinctwindow of time. This could be funded from the savings that wouldresult from Freddie no longer having to pay the MAP fee to mortgageoriginators. While early adoption would not eliminate many of theother flaws of the program, such as the potential for securitydegradation, a high conversion rate would greatly reduce thechances of both fragmenting the market and increasing costs forhomeowners.
- Performance of the securities must be monitoredand dispersion must be minimized; “alignment” is notsufficient.As we discussed above, the advent of the Single Security willpreclude market forces from being able to police Fannie and Freddieto ensure that the quality of the securities offered does notsuffer. In order to avoid a “race to the bottom,” FHFA must bevigilant about monitoring and minimizing any dispersionand ensuring that performance does not degrade over time. Simplyfocusing on “alignment,” as the FHFA has said it will do, will notnecessarily achieve this goal. Indeed, under the current proposal,if Freddie Mac securities are already performing poorly, Fannie Maecreating equally poor securities would be theoretically acceptableas they would be “aligned.” Generally, however, everyone would bemade worse off: The marketplace would receive lower qualitysecurities, and as such, prospective homebuyers would be faced withhigher mortgage rates.
Broader reform first
Given the healthy functioning of the agency mortgage market todayand the real chance of significant disruption from the rollout ofthe Single Security, we believe that FHFA should put the SingleSecurity proposal on pause and wait for Congress to advance housingfinance reform – an issue that both Chairman Mike Crapo and rankingmember Sherrod Brown on the Senate Banking Committee have said is apriority.
Why should FHFA wait? We believe that many of the issues that the SingleSecurity proposal is trying to address would be resolved under GSE reform,specifically if the reform includes changing the implicit full faith andcredit guarantee of the U.S. government to an explicit one for all Fannieand Freddie securities. Adding a full faith and credit guarantee toexisting Fannie and Freddie securities, as well as to the new SingleSecurity, would render the dual-agency guarantee issue obsolete and makeall of these securities definitively superior to existing Fannie andFreddie securities. The result would likely be higher prices for bonds inthe secondary market and ultimately lower mortgage rates for homebuyers.The Single Security would then be a win for all.1 As it relates to issuance; source: Bloomberg as of March 2017.