One of the most effective reforms to Fannie Mae and Freddie Mac during their 14 years in conservatorship was the 2019 introduction of the Uniform Mortgage Backed Security (UMBS), a single security backed by mortgages guaranteed by either or both institutions.

In the prior system, in which each government-sponsored enterprise (GSE) issued its own securities, investors preferred Fannie Mae securities to Freddie Mac securities, making Fannie Mae securities more liquid and more valuable. To maintain a market in its securities, Freddie Mac had to compensate lenders for the difference in value of about $400 million per year. This bifurcated system reduced the profits Freddie Mac sent to taxpayers and created a prohibitive barrier to meaningful GSE reform, as it would be impossible to transition to a healthier housing finance system if Fannie Mae retained such a market advantage.

Transitioning to a single security thus saved taxpayers hundreds of millions of dollars a year and helped pave the way for long-term reform.

The UMBS was years in the making and enormous in its complexity and the stakes involved, requiring the Federal Housing Finance Agency (FHFA) and the GSEs to transform a multitrillion-dollar market that borrowers depend upon to lock in their mortgage rates long enough to close on a home purchase. Remarkably, the transition did not disrupt the market. Indeed, the market has since expanded considerably, from $4.7 trillion at the time of the transition to $6.4 trillion today.

One reason the transition has worked is that the new security allows for the commingling of Fannie Mae and Freddie Mac’s securities. Each GSE still issues its own securities, but these securities can be delivered into resecuritizations collateralized by the securities of either or both GSEs. Increasing the fungibility of the two underlying securities reduces the risk that one will trade at a discount to the other.

But a monkey wrench has been thrown into the mix. On June 14, the GSEs announced that they will each charge a 50 basis-point fee for commingled securities issued on or after July 1 to cover the additional capital required for such securities under the recently implemented Enterprise Regulatory Capital Framework (ERCF).

The impact of the capital rule

The ERCF imposes a capital charge on each GSE for guaranteeing the security of the other GSE. Each enterprise is obligated under its guarantee to fund any shortfall should the other enterprise fail to make a payment due on its securities. The risk weight is 20 percent, the same as that imposed on banks for holding mortgage-backed securities (MBS).

With a 20 percent risk weight on an 8 percent capital charge, the GSEs must hold 1.6 percent of capital against the position. Assuming the return on capital before tax is 11 percent and the interest earned on that capital is 2.5 percent, the after-tax cost of the capital to the GSEs is 8.5 percent per year, or $0.136 per $100. Assuming the securities have a five-year duration, an up-front charge of $0.50 makes sense. Indeed, it is less than what is needed to cover the $0.68 cost to the GSEs. 

If the GSEs did not charge a fee to cover the capital charge, setting aside the needed capital would cost them revenue at a rate proportionate to the amount of the commingled pools they securitized. For a sense of the scale involved, if they had to absorb the capital charge on all commingled securities issued to date ($354.4 billion as of March 31), they would need to set aside $1.8 billion. Although that may seem to be a fanciful reference point, if the Federal Reserve were to consolidate the GSE components of its $2.7 trillion in MBS holdings, as it has indicated it will begin to make it easier to manage its holdings, its commingling of hundreds of billions of dollars of Fannie Mae and Freddie Mac MBS would trigger a hit to GSE revenues of roughly this order of magnitude.

Implications for the UMBS

Although the fee makes sense given the capital charge, it may pose some risk to the UMBS over the long term. By eliminating the fungibility of the GSEs’ commingled securities, investors may begin to pay more for Fannie Mae’s security, again forcing Freddie Mac to pay lenders a premium to make up for the weaker investor demand for their security.

The FHFA has taken steps to align the prepayment speeds of the GSEs’ two securities, which has mitigated how differently investors value them. But the degree to which investors are folding Freddie Mac MBS into Fannie Mae resecuritizations at a much higher rate than the reverse signals that many market participants still consider Freddie Mac’s security the weaker of the two securities. Without the ability to commingle the GSEs’ securities, this difference in perceived value may gradually lead to a divergence in pricing and a return to the challenges faced before the UMBS. It may also reduce overall liquidity in the single security, which would ultimately flow through to borrowers in the form of higher mortgage rates.

Commingling, by the Numbers

Source: Fannie Mae Monthly Summary and Freddie Mac Monthly Volume Summary, March 2022, and the Urban Institute.
Notes: MBS = mortgage-backed securities.

What needs to be done

The culprit here is the capital rule. As we have argued elsewhere, the rule introduced by the FHFA’s prior director had many flaws, putting us on a path toward a riskier, less stable housing finance system. The new director has addressed many of these flaws with the amended capital rule published on February 25, 2022. But the UMBS fee was left in place and may weaken the system by forcing the GSEs to take steps that may gradually undermine the UMBS.

The FHFA should suspend and reassess the capital provision and either correct course or provide the market with greater confidence that the capital provision isn’t needed, ideally before the market begins to adjust in ways that will make repairing any damage to the UMBS more difficult and costly. To give the FHFA time to reassess and adjust course if needed, the Federal Reserve should delay the consolidation of its GSE MBS holdings.