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Securitized Perspective published on May 29, 2019

What to Expect from the Launch of UMBS

On June 3, Fannie Mae (FNMA) and Freddie Mac (FHLMC) will issue the first uniform mortgage-backed security (UMBS), a common joint-venture security that will trade in the to-be-announced (TBA) market for fixed-rate agency mortgage-backed securities (MBS). Given the size of the U.S. agency mortgage market ($7.3 trillion1) and the complexities of mortgage trading, the implementation of UMBS marks one of the biggest operational changes to this sector in decades.

The launch of UMBS is a culmination of seven years of Federal Housing Finance Authority (FHFA) efforts to create a single-security solution for MBS trading that will help deepen liquidity and promote additional fungibility for the TBA market,2 which is the engine of the 30-year fixed-rate mortgage that is the backbone of U.S. housing. Importantly, FNMA and FHLMC are not simply merging. With the launch of UMBS, FNMA bondholders will see their FNMA holdings automatically migrate to UMBS. FHLMC bondholders will have the choice to exchange their holdings for UMBS or to continue holding their FHLMC bonds.

A Marriage of Not-Quite Equals

FNMA and FHLMC are not interchangeable, but they do share important structural characteristics. Both government-sponsored enterprises (GSEs) purchase conventional (or conforming) mortgages. “Conventionals” have the strongest credit profiles among mortgage borrowers, given stricter criteria for loan size, credit quality, loan-to-value ratio and income. In addition, FNMA and FHLMC loans are implicitly guaranteed by the U.S. government. Agency MBS investors are protected from defaults on the underlying mortgage loans, in that the GSE guarantee makes the investor whole.

Despite these similarities, FHLMC’s mortgage pools have historically traded at lower prices than FNMA’s primarily because FNMA is more liquid and, historically, FHLMC MBS has prepaid slightly faster than FNMA MBS. FNMA has a much larger market in terms of supply with more than $2 trillion outstanding, versus $1.4 trillion for FHLMC.3

Trading volume in FNMA has far outpaced that of FHLMC, and, leading up to the launch of UMBS, we have seen daily trading in FHLMC TBAs drop considerably (Figure 1).

With UMBS, the FHFA’s aim was to help eliminate these differences in pricing, increase liquidity and ultimately preserve access and affordability of the 30-year fixed rate mortgage to homebuyers. Figure 2 shows that the market is heading toward the FHFA’s goal. Pricing of FNMA and FHLMC bonds has converged in anticipation of the launch of UMBS. Historically, FHLMC TBAs (known as Golds) have traded at lower dollar prices than similar Fannie TBAs. However, Figure 2—which tracks the dollar price difference between like-coupon FHLMC and FNMA TBAs—shows that FHLMC MBS has outperformed FNMA MBS, compressing the historical discount on FHLMC MBS.

Freddie Mac Liquidity Post-Launch

We expect most holders of FHLMC bonds to gradually exchange their debt for UMBS given that FHLMC liquidity is expected to fall significantly. We have already seen some early exchanges occurring, which started in May; through the week ending May 17, 2019, 720 CUSIPs have been processed totaling over $23 billion in unpaid balance.

In our view, one of the biggest implications for not exchanging is the expected resulting decline in liquidity for the legacy FHLMC TBA market. To explain why, it is worth revisiting the importance of the TBA market to MBS pricing and liquidity.

The TBA market is the benchmark for MBS pricing and the biggest driver of liquidity in the sector. When an MBS is traded, it can often be delivered into a to-be-announced, or “TBA” contract; in a TBA trade, the exact securities to be delivered to the buyer are chosen just before delivery rather than at the time of the original trade, increasing efficiency and flexibility for traders. The TBA market for Freddie Mac will effectively be going away. If an investor owns Freddie MBS and doesn’t exchange it for UMBS, the investor may find it challenging to transact that security down the road without that TBA backstop. By contrast, if the investor exchanges Freddie MBS for UMBS, the investor could rely on the liquid UMBS TBA market. As mentioned, investors holding Fannie Mae MBS will see their holdings automatically become UMBS.

As of May 28, 2019, prior to the launch of UMBS, FHLMC bondholders have a 45-day payment delay before receiving their monthly cash flow of principal (scheduled and unscheduled) and interest. Following the launch, UMBS—and legacy FNMA—will have a 55-day payment delay. Therefore, FHLMC bondholders must be compensated for receiving their cash flows 10 days later. The exchange mechanics consist of two parts:

  • First, the investors exchange their legacy FHLMC MBS with Freddie Mac and receive a new mirror security UMBS.
  • Second, FHLMC bondholders will receive a lump-sum cash payout that equates to the present value of the cash flows received 10 days later.

What’s on Our Radar?

Even though pricing between FNMA and FHLMC has converged, much of the challenge and uncertainty of UMBS implementation revolves around whether FNMA and FHLMC securities really will have similar collateral profiles and more-aligned prepayment speeds. FHFA’s final rules include several directives to help align the two markets. For example, FNMA and FHLMC are prevented from offering weighted-average coupons (WAC) that are significantly higher than the underlying mortgage rates on each pool—a tactic that could be used to distort prepayment speeds. The spread between the WAC on the MBS and the interest rate paid by the borrowers can be no more than 112.5 basis points (bps).

In addition, the GSEs are limited to a maximum 50bps servicing fee for each underlying loan, according to the final rules. However, a key element of combining FNMA and FHLMC is aligning the prepayment speeds, or the rates at which underlying mortgages are repaid. Prepayment speeds are important determinants of MBS pricing (see The Case for Agency MBS in a Diversified Portfolio). In the past, speeds have diverged in periods of market distress.4 The final rules include guidelines for what constitutes misalignment in prepayment speeds between FNMA and FHLMC.

As UMBS launches, we are monitoring the following trends:

  • Operational Hang-Ups: As discussed, the smoothness of the UMBS implementation largely hinges on the ability of the FHFA to reduce the existing price gaps between FNMA and FHLMC that mainly come out of competition and liquidity differences.
  • The Free Float: As liquidity deepens, the free float of mortgages could effectively double, which may impact supply-and-demand dynamics in the future.
  • GSE Reform: The MBS market is still heavily influenced by concerns over GSE reform, and uncertainties loom given ongoing headlines on legislation.
  • Fed Holdings: As we discussed in our April market commentary, the Fed is the single largest holder of FHLMC MBS. It has indicated in recent meetings that it is preparing to exchange its legacy FHLMC securities which could influence how the MBS indices evolve as they typically do not exclude Fed holdings. This could ultimately drive the speed at which the overall market accepts this initiative.

We will closely monitor the implementation of UMBS and look forward to keeping clients informed of credit and pricing impacts to the agency MBS market.

 

[1] SIFMA, as of May 2019.

[2] In a TBA trade, the exact securities to be delivered to the buyer are chosen just before delivery, rather than at the time of the original trade.

[3] SIFMA, Nomura Securities, as of May 2019.

[4] FHFA Prepayment Monitoring Report, First Quarter 2018, data for Prepayment Comparison for 30‐Year, TBA‐Eligible MBS, All Coupons, March 2008 through March 2018. 

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