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
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
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
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
Performance of the securities must be monitored
and dispersion must be minimized; “alignment” is not
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
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.