Higher Mortgage Rates Are Likely With Proposal of ‘Single Security’

The Federal Housing Finance Agency (FHFA) – the entity that oversees mortgage giants Fannie Mae and Freddie Mac, which are currently in federal conservatorship and collectively constitute 71% of the mortgage market¹ – recently completed a roadshow on its “Single Security” proposal, which would represent a significant change to the current mortgage market.

While we appreciate the primary goals of the FHFA proposal – increased liquidity and reduced costs to taxpayers – we have serious concerns about the proposal as is and worry that without significant modifications, it could actually lead to reduced liquidity, and more importantly, to higher mortgage rates for those purchasing a home and for those homeowners needing to refinance.

Given these reservations, we welcomed the recent FHFA announcement that it intends to delay the rollout of the Single Security to 2019. Not only should this additional time provide FHFA the opportunity to address some of the structural issues associated with the current proposal (outlined below), it hopefully will provide Congress the needed time to make progress on housing finance reform – a critical step, in our view, before the FHFA moves 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 collectively the “agencies”) separately issue and guarantee mortgage-backed securities that are backed by pools of residential mortgage loans. For a variety of reasons, including historically faster prepayment speeds and reduced market liquidity, Freddie Mac securities consistently trade at a discounted price (and at higher rates) to those issued by Fannie Mae. Consequently, in order to induce mortgage originators to do business with Freddie Mac, the company has had to subsidize mortgage originators – called a “mortgage adjusted price” or “MAP.” Indeed, Freddie has spent hundreds of millions annually (billions cumulatively) on this subsidy, which has led to reduced profits to Freddie, and ultimately less money to the Treasury Department (since Freddie and Fannie currently sweep profits to Treasury under the 2010 Stock Purchase Agreement).

The Single Security proposal seeks to eliminate price differences between Fannie and Freddie’s securities, and therefore eliminate the need for Freddie to subsidize originators. This would be accomplished by creating a unified mortgage-backed security: New Fannie or Freddie securities would be issued under a Single Security structure, and existing Fannie and Freddie securities could be converted into the new structure. FHFA asserts that this Single Security would reduce costs while also increasing mortgage market liquidity by unifying the two markets.

What could go wrong?

To be sure, this plan sounds appealing. However, as a long-time, large buyer of agency mortgage-backed securities, we have several concerns with the current proposal:

A race to the bottom? Today, Fannie Mae and Freddie Mac compete with one another on the quality of the mortgage-backed securities they issue. If Freddie issues securities backed by mortgage loans with less appealing characteristics for investors (e.g., credit quality, prepayment characteristics), the market will punish Freddie by demanding a discount on the price of those securities and viceversa. Under the Single Security proposal, this ability of investors to police Fannie and Freddie and differentiate on price to ensure each entity is delivering the best product to the marketplace would be lost. Without the market as the enforcer, Fannie and Freddie would lose their incentive to compete on the quality of their product, which could lead to a “race to the bottom.” This would likely lead to a lower quality security for investors. While FHFA has asserted that there will be “alignment” between the securities issued by Fannie and Freddie under the new Single Security structure, FHFA does not have any existing mechanism to enforce this under the current proposal.
Perversely, markets could become less liquid, leading to higher mortgage rates. One of the primary objectives behind the Single Security proposal is to improve liquidity in the mortgage market, but we have two concerns regarding this premise. First, the mortgage market is one of the most liquid, well-functioning markets worldwide, so the proposal is solving for a market problem that, in our view, does not exist. Second, liquidity would only improve from its already-strong levels if holders of legacy Fannie and Freddie securities choose to “convert” into the new Single Security. The problem is that there is no incentive to convert, as holders of legacy securities would be charged a fee for doing so under the current proposal.

Practically, if investors do not convert, the market could ultimately become trifurcated with smaller floats in each segment: legacy Fannie Mae, legacy Freddie Mac and a new Single Security market. This is similar to the experience in 1990, when Freddie Mac introduced a new security (Freddie “Golds”), which should have been preferred by investors. But they chose not to convert, leading to market 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 confusion surrounding which agency is the ultimate guarantor of the new security if the issuer is different from the one that packaged the loans (e.g., Fannie is the new issuer but the underlying collateral loans are packaged by Freddie). We worry that it is unrealistic that Fannie and Freddie, which are legally separate entities, will unconditionally promise to guarantee the other’s loans without having evaluated the underlying collateral. We think this could be addressed with explicit contractual language, but investors need to be 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 be able to deliver on its promise to increase market liquidity is if there is widespread conversion to the new Single Security. Under the existing proposal, there would be a cost to conversion, which we think will dissuade existing holders of agency bonds from converting, leading to a more fragmented market and likely higher mortgage rates. In order to avoid this, we believe FHFA should not only abolish the proposed fee, but instead offer an incentive to investors who convert within a distinct window of time. This could be funded from the savings that would result from Freddie no longer having to pay the MAP fee to mortgage originators. While early adoption would not eliminate many of the other flaws of the program, such as the potential for security degradation, a high conversion rate would greatly reduce the chances of both fragmenting the market and increasing costs for homeowners.
Performance of the securities must be monitored and dispersion must be minimized; “alignment” is not sufficient. As we discussed above, the advent of the Single Security will preclude market forces from being able to police Fannie and Freddie to ensure that the quality of the securities offered does not suffer. In order to avoid a “race to the bottom,” FHFA must be vigilant about monitoring and minimizing any dispersion and ensuring that performance does not degrade over time. Simply focusing on “alignment,” as the FHFA has said it will do, will not necessarily achieve this goal. Indeed, under the current proposal, if Freddie Mac securities are already performing poorly, Fannie Mae creating equally poor securities would be theoretically acceptable as they would be “aligned.” Generally, however, everyone would be made worse off: The marketplace would receive lower quality securities, and as such, prospective homebuyers would be faced with higher mortgage rates.

Broader reform first

Given the healthy functioning of the agency mortgage market today and the real chance of significant disruption from the rollout of the Single Security, we believe that FHFA should put the Single Security proposal on pause and wait for Congress to advance housing finance reform – an issue that both Chairman Mike Crapo and ranking member Sherrod Brown on the Senate Banking Committee have said is a priority.

Why should FHFA wait? We believe that many of the issues that the Single Security proposal is trying to address would be resolved under GSE reform, specifically if the reform includes changing the implicit full faith and credit guarantee of the U.S. government to an explicit one for all Fannie and Freddie securities. Adding a full faith and credit guarantee to existing Fannie and Freddie securities, as well as to the new Single Security, would render the dual-agency guarantee issue obsolete and make all of these securities definitively superior to existing Fannie and Freddie securities. The result would likely be higher prices for bonds in the 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.

DISCLOSURES

Mortgage -backed securities may be sensitive to changes in interest rates, subject to early repayment risk, and their value may fluctuate in response to the market’s perception of issuer creditworthiness; while generally supported by some form of government or private guarantee, there is no assurance that private guarantors will meet their obligations. Investors should consult their investment professional prior to making an investment decision.

This material contains the opinions of the manager and such opinions are subject to change without notice. This material has been distributed for informational purposes only and should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed. No part of this material may be reproduced in any form, or referred to in any other publication, without express written permission. PIMCO is a trademark of Allianz Asset Management of America L.P. in the United States and throughout the world.

PIMCO Investments LLC, distributor, 1633 Broadway, New York, NY, 10019 is a company of PIMCO.

Higher Mortgage Rates Are Likely With Proposal of ‘Single Security’

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