The Pitfalls of FHFA's Plan for a Single GSE Mortgage Security

WASHINGTON — While the financial services industry is solidly behind a Federal Housing Finance Agency plan to create a single structure for Fannie Mae and Freddie Mac securitizations, the proposal also carries significant risk.

The agency provided key details this week on how it wants to move forward, saying it will be a "multi-year" effort. But some in the industry fear that is too slow, arguing the regulator needs to speed up the process while the Federal Reserve Board is still keeping interest rates low.

"It could be completed in 18 months or less," said David Stevens, the head of the Mortgage Bankers Association, and a former executive at Freddie.

Stevens said he understands the need to move cautiously, particularly for Freddie, which under the plan would have to adopt Fannie's pooling features (the proposal is easier on Fannie, which would mainly have to adopt Freddie's securities disclosures).

The market is also gigantic, with $4.2 trillion in outstanding mortgage-backed securities.

"If you move too fast, it could disrupt positions" investors have in the market, Stevens said.

Still, with the Fed already reducing its purchases of mortgage-backed securities and expected to start raising interest rates sometime next year, there is an incentive to move sooner rather than later. Stevens noted that the process of creating a new single security structure will eventually lead to the exchange of legacy Freddie MBS (which the company calls "participation certifications") into new issuances.

"It is a lot easier to exchange a PC with 4% coupon into a new MBS with a 4% coupon. Changing a 4% coupon into a 5.5% coupon is more difficult," Stevens said. "It will be better to do the exchange before the Fed starts to sell off its MBS holdings."

In the long-run, the FHFA's plan will provide a benefit for Freddie, which currently charges a lower guarantee fee in an effort to remain competitive with Fannie.

The proposal would unify the structure of both government-sponsored enterprises' mortgage-backed securities, which theoretically would improve the pricing of Freddie's MBS.

Fannie MBS is considered the benchmark in the securities market due to its volume and structure. Fannie issued $161.2 billion in MBS during the first half of this year, compared to Freddie, which issued $107.7 billion in PCs during the same six-month period.

In terms of pricing, Freddie charges a 56.7 basis point guarantee fee, compared to Fannie, which charges 62.6 basis points.

As a result, industry representatives and analysts see more potential disruption to Freddie in the FHFA's plan.

"Key to the FHFA approach now is to take great care not to do anything to the TBA market or to destabilize Freddie along the way" to a single MBS, wrote Federal Financial Analytics in a note to clients issued on Wednesday. 

FHFA will have to make sure the handover of the old PCs to the new MBS does not "undermine Freddie's ability to purchase mortgages before the transfer date or stay viable thereafter," said the note, which was entitled "Kiss Your PC Good-Bye."

Isaac Boltansky, an analyst for Compass Point Research and Trading, said it is important to ensure investors can exchange legacy Freddie's MBS for a comparable single security envisioned by FHFA.

An "exchange option of legacy Fannie MBS to the single security may not be necessary," he wrote in a note to clients.

But Boltansky said the FHFA is not poised to move quickly given the details of the proposal.

"We believe that the FHFA's effort to create a single security structure is in the nascent stages of development given the general nature of the FHFA's questions, the commentary of the request (for input), and the considerable to-do list at the FHFA," Boltansky said. 

The timeline for creating the single security will be "measured in years," he added.