June’s Agency Mortgage Market Changes: What Investors Need to Know

Jeff Dutra

Jeff Dutra, CFA

Senior Portfolio Manager, Structured Finance

Background

In one of the most significant developments since entering conservatorship, Fannie Mae and Freddie Mac have been directed by the Federal Housing Finance Agency (FHFA) to create a joint technology and operational platform for mortgage issuance, operations and reporting.  Known as the Common Securitization Platform (CSP), it will be instrumental in facilitating the creation of a “Single Security” or Uniform Mortgage-Backed Security (UMBS) for government sponsored Enterprises to issue securities into the Agency RMBS (Residential Mortgage-Backed Securities) TBA market. 

Historically, GSEs issued securities in independent and distinct To-Be-Announced (TBA) markets, and while fundamentally similar, they differed on the payment delay for issued pools (55-days for Fannie Mae and 45-days for Freddie Mac).

What are the potential benefits?

The change from separate TBA markets to UMBS is designed to:

  1. Enhance liquidity in the TBA market as the issuance will be combined
  2. Materially reduce or eliminate the subsidies that Freddie Mac provides to lenders and,
  3. Facilitate housing finance reform by allowing new entrants to enter the RMBS guarantee business. 

What happens now?

June 3, 2019 marks the “go-live” date for the Single Security Initiative.

In order to facilitate a single UMBS market, payment features of the new UMBS will be based on current Fannie Mae RMBS characteristics. These securities will be immediately deliverable into the new UMBS contract and the Fannie-only TBA will disappear. Holders of legacy Freddie Mac securities will be able to exchange their Freddie Mac 45-day securities for mirrored 55-day UMBS securities. This exchange is not mandatory and securities can be exchanged at any time. The mirrored security will have exactly the same underlying collateral, but will have a new CUSIP, prefix, pool number, issuance date, and of course, a 55-day delay. Freddie Mac will compensate holders of 45-day delay securities for the value of the 10-day difference. 

Accounting implications

Importantly, the SEC has said that for accounting purposes the exchange will be viewed as a modification of an existing security, not a sale, and will not be a taxable event for security holders.  Furthermore, the IRS has provided regulatory guidance for UMBS pools regarding diversification standards for investors in segregated asset accounts.  

Index composition

For benchmark purposes, representatives from all of the major RMBS index providers (Bloomberg, FTSE, ICE, and JPMorgan) have provided forward guidance stating they would create a separate sub-index of MBS for the new 55-day UMBS pools, independent from the legacy 45-day Freddie Gold PCs and 55-day Fannie UMBS.  Thus, “Agency-backed” RMBS indices will be comprised of three components: legacy FNMA, legacy FHLMC, and UMBS.

Our view: The overall market impact is positive

We see this change as part of an ongoing evolution within the aggregate Agency RMBS market toward homogeneity.  Over the past few years, new pool issuance has migrated from multiple, smaller pools of loans, to larger, multi-originator pools with thousands of loans. UMBS implementation further promotes the evolution of the market into larger, SUPER pools and Collateralized Mortgage Obligations (CMOs) as dealers can create them with Fannie or Freddie backing, or both! For the RMBS investors, this is a positive development as improved diversification of loans is easily achieved via these large, homogenous pools.

We also expect the UMBS initiative to further bridge historical prepayment discrepancies that existed between Fannie Mae and Freddie Mac pools, and in fact, this is one of the stated goals of their regulator.  The success of commingling Fannie and Freddie issued securities is contingent on alignment of prepayment speeds.  To that end, FHFA has released rules specifying ‘misalignment’ measurement and tolerances for prepayment difference by each coupon and cohort. The rule also includes a provision that caps the rate difference, or spread, in pools created and borrower rates for each pool. The Single Security has long been seen as a critical component of GSE reform in which the securities, not the guarantor entities, receive some sort of explicit or implicit government guarantee.  In this system, multiple private guarantors could enter the market and compete with Fannie and Freddie immediately by “piggy-backing” on the liquidity of the Single Security - UMBS. 

What we are keeping an eye on: Evolving future opportunities

Although it may be part of the evolution, increased homogeneity may limit or decrease the amount of potential alpha opportunities within RMBS. It will be imperative that RMBS investors and managers adapt to these changes quickly by enhancing their research and security-level analysis, utilize sophisticated quantitative systems, and potentially the most important - relying on highly skilled portfolio managers who are better able to discover value outside of the consensus.

This commentary has been prepared by Voya Investment Management for informational purposes. Nothing contained herein should be construed as (i) an offer to sell or solicitation of an offer to buy any security or (ii) a recommendation as to the advisability of investing in, purchasing or selling any security. Any opinions expressed herein reflect our judgment and are subject to change. Certain of the statements contained herein are statements of future expectations and other forward-looking statements that are based on management’s current views and assumptions and involve known and unknown risks and uncertainties that could cause actual results, performance or events to differ materially from those expressed or implied in such statements. Actual results, performance or events may differ materially from those in such statements due to, without limitation, (1) general economic conditions, (2) performance of financial markets, (3) changes in laws and regulations and (4) changes in the policies of governments and/or regulatory authorities. The opinions, views and information expressed in this commentary regarding holdings are subject to change without notice. The information provided regarding holdings is not a recommendation to buy or sell any security. Fund holdings are fluid and are subject to daily change based on market conditions and other factors.

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