Progress on the single security is an unheralded success
Like so many others following policymaking in housing finance, we often focus on what should be fixed or improved. We’ve bemoaned the tight credit box, the inadequate supply of housing, and the need for housing finance reform.
But an important effort by the government-sponsored enterprises (GSEs) Fannie Mae and Freddie Mac, and their regulator, the Federal Housing Finance Agency (FHFA), deserves our praise. Their creation of a single agency security will save taxpayers millions while making the market more responsive to lenders’ and borrowers’ needs.
Disparate pricing between Fannie and Freddie has cost taxpayers as much as $1 billion annually
For more than four decades, Fannie and Freddie have each issued its own distinct mortgage-backed security. But the existence of two different securities has created a problem: disparate pricing that costs taxpayers a lot of money to equalize.
Historically, Freddie’s securities often trade at a lower price than Fannie’s, spurring Freddie to subsidize the deals so originators will participate in Freddie’s securities pools. This subsidy ensures that Freddie retains adequate market share, but it costs US taxpayers as much as $1 billion a year.
This arrangement compromises liquidity in the system and exposes taxpayers, as the majority shareholders in the enterprise, to unnecessary losses. As we’ve explained previously, moving to a single security will help overcome this pricing disparity.
Pricing has converged in recent months
Interestingly, this pricing disparity has all but disappeared since the single security effort began. The figure below shows that in 2012 and 2013, Freddie’s 3, 3.5, and 4 percent coupons traded at more than a $0.30 discount to their Fannie Mae counterparts. This narrowed to around $0.15 in 2014–15 and had largely converged by early 2017.
This price convergence has occurred in part because prepayment speeds have converged. Freddie Mac speeds used to be faster than Fannie Mae speeds, reflecting a slightly different issuer mix and differences in the implementation of the streamlined modification program.
Since 2013, the deliberate alignment of policies between the GSEs has made prepayment speeds similar, as shown in the figure below.
Some may ask, for good reason, why policymakers should bother moving to a single security if the problem has disappeared. The answer is that the convergence is not sustainable in the absence of a single security. The pricing disparity was partly caused by the lower liquidity of Freddie Mac securities. If this issue remains unaddressed, it will eventually cause the disparity in the two securities to re-emerge.
Moreover, the price convergence reflects the fact that the market anticipates that the single security is likely to become a reality. If you remove that assumption, pricing disparity will almost surely return.
The path forward is promising
For the move to a single security to work smoothly, price convergence must occur first. Under the single security, Freddie Mac and Fannie Mae will continue to issue their individual securities, but both can issue into Fannie Mae Mega pools and real estate mortgage investment conduits (REMICs) and Freddie Mac Giant pools and REMICs. For this to happen, the securities need to be fungible. The market recognizes this and has begun pricing that into their investments.
Currently, only Freddie Mac uses the Common Securitization Platform, the platform from which the single security will be issued. Fannie will convert over in the second quarter of 2019, when the single security is expected to go live.
Although the Securities Industry and Financial Markets Association will need to endorse the final step to a single security, the key obstacle to their support—Freddie Mac’s faster prepayment pace—has been removed.
Remaining considerations need to be addressed, but none are sufficiently large to hold up the emergence of the single security. To name a few issues yet to be worked out:
- holders of existing Freddie securities will have to convert to the new security;
- policymakers will have to decide whether Freddie exchanges will be treated as modifications of an existing security, or the sale of one and re-purchase of another, which will have tax consequences; and
- a host of questions surrounds regulators’ and investors’ handling of limitations on concentrations on one or the other security, given their fungibility.
The bottom line, though, is that progress toward a major development in the secondary mortgage market is under way. This will be a significant achievement, making the market more responsive to borrower and lender needs, boosting competition, and increasing the availability of mortgage credit.
Photo by Logan Mock-Bunting/Getty Images.