Single Security Helps Today’s Housing Finance System and Lays the Groundwork for Tomorrow's
Earlier this summer, the common securitization platform (CSP) developed by Fannie Mae and Freddie Mac (government-sponsored enterprises, or GSEs) and the Federal Housing Finance Agency (FHFA) issued the first uniform mortgage-backed security (UMBS), a new security backed by mortgages guaranteed by either Fannie Mae or Freddie Mac.
Moving away from Fannie and Freddie’s issuance of their own distinct, competitive securities was an enormous undertaking, requiring a dramatic transformation of a $5 trillion financial market in which hundreds of billions of dollars of Fannie and Freddie mortgage-backed securities (MBS) are bought, sold, and traded every day.
The smooth functioning of this market is critical to US homebuyers’ ability to get a mortgage, so the stakes for the launch of the UMBS were high and the launch had to be flawless. And it was.
A single uniform security saves taxpayers money
For decades, Fannie and Freddie issued two separate mortgage-backed securities with different securitization practices, terms, and pricing. For many reasons, MBS investors strongly preferred Fannie’s security, making it more liquid and more valuable than Freddie’s security. When selling securities into the market, lenders received a better price for Fannie’s securities, even when the loans underlying both securities had identical attributes.
To encourage the sale of its securities, Freddie had to compensate lenders for the difference—to the tune of hundreds of millions of dollars a year. This cost reduced their profitability, which, since conservatorship, has meant less money going to the taxpayer.
The FHFA, Fannie Mae, and Freddie Mac created the UMBS largely to eliminate this inefficiency. While Fannie and Freddie continue to issue their own securities, the securities of either GSE can now be delivered into a single security, eliminating the liquidity differences that arise from having two separate securities.
Moreover, Fannie securities can be resecuritized into Freddie pools and vice versa, and these resecuritized pools are also good delivery into the UMBS. This mutual deliverability requires the securities to have identical features (disclosures and payment delay), and the GSEs must be highly aligned in the policies that affect their prepayment speeds.
An early test for the launch of the UMBS will be how it affects investor appetite for the GSEs’ MBS. Early data on UMBS trading volumes—a key metric of how investors are reacting to the new security—are very encouraging. The average daily trading volume for agency MBS (which includes the UMBS) was higher in June ($267 billion) than it was in April ($250 billion) or May ($232 billion), according to the Securities Industry and Financial Markets Association. There was no decline in MBS pricing attributable to the launch of the UMBS.
Additionally, legacy Freddie Mac securities must be converted to new securities before they can be delivered into the UMBS (to align the payment delay), and close to 10 percent had been converted by early July.
Although we need several months of data for further verification, early data suggest the launch has gone very smoothly.
Helping pave the way for housing finance reform
By reducing the significant competitive advantage that Fannie enjoyed over Freddie, it also helps open the way to additional competitors over time. It is still difficult to imagine how a new entrant would overcome the legacy players’ enormous liquidity advantage, but moving to a single security helps ease that barrier.
But the UMBS doesn’t entirely remove the significant barriers to entry. The common securitization platform that facilitates UMBS issuance was designed to handle a relatively narrow range of bond administration functions for Fannie and Freddie. To become the kind of market utility that gives additional guarantors a shot at entering the market in a meaningful way, it would need to expand not only the guarantors it can support but also the functions it supports. But it is a meaningful first step.
So what does the UMBS mean for how the guarantor market would develop with new entrants? A uniform mortgage-backed security requires not only consistency across securitization practices (which the CSP facilitates) but also substantial alignment with the credit underwriting, servicing, and loss mitigation policies that collectively determine how loans perform and prepay.
Fannie and Freddie maintain dozens of sophisticated systems that evaluate appraisals, gather data from myriad sources, estimate home values, and assess credit risk using their automated underwriting systems. Over the past several years, the FHFA, Fannie Mae, and Freddie Mac have developed policies to achieve this alignment. Any new guarantor would have to develop new systems or obtain the infrastructure from the existing entities, and these systems would need to be aligned with the current systems and policies to ensure investor acceptance.
In sum, the UMBS requires substantial alignment among business policies and systems regardless of the number of guarantors.
The creation of the UMBS is an important step forward in the current system. It not only removes an expensive inefficiency in the current system, but it also lays the groundwork for deeper structural reforms in the years to come.
People tour a home for sale during a broker open house on April 16, 2019 in San Francisco, California. (Photo by Justin Sullivan/Getty Images)