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FHFA plan for GSE prepayment parity — but without teeth

| September 14, 2018

This document is intended for institutional investors and is not subject to all of the independence and disclosure standards applicable to debt research reports prepared for retail investors.

Fannie Mae and Freddie Mac next June will start blending their separate MBS programs into one single security in an effort to wring out some long-standing inefficiency in the TBA market, but investors worry that the union could encourage each enterprise to let prepayment quality fall. This would damage investors and ultimately raise mortgage rates. The enterprises’ regulator has come out with a well-meaning plan to keep prepayments in line, but the plan lacks teeth.

Prepayment speed alignment has improved Gold execution

Since planning for a single security started in 2012, investors have worried that differences in prepayments between the enterprises would force prices to the lowest—or, more accurately, the most negatively convex—common denominator. For years, relatively lower liquidity and greater negative convexity hurt pricing of Freddie Mac securities. Freddie Mac had to compensate originators for the pricing shortfall, leading the enterprise in some years to spend hundreds of millions of dollars in subsidies. A single security was meant to erase the liquidity differences, but prepayment differences looked like a harder problem.

Efforts by the enterprises to align prepayment speeds over the last few years have clearly improved the execution of Freddie Mac TBA contracts. Gold 4.0%s, for example, traded 12 ticks behind Fannie in December 2013, while on September 12, 2018 they closed 0.5/32s above Fannie. This is within 1/32 to 2/32 of the theoretical premium Golds should command given the shorter 10-day delay. Better execution has saved Freddie Mac a substantial amount of money that would have been used to subsidize the difference between their and Fannie TBA prices. However, under single security, speed misalignment would hurt execution of both GSEs’ pools.

The FHFA’s recent announcement may not alleviate concerns

The Federal Housing Finance Agency and the enterprises have not yet presented a formal process to correct speed differences that might arise. The FHFA on September 12 proposed a rule (here) that largely codifies existing policies and practices, which consist of regular reporting and investigation of misaligned prepayment speeds. However, there is no mention of remedies or penalties. Even in the case of a “material misalignment”, defined as at least a 3 CPR difference at the cohort-level (term/coupon/origination year), the FHFA only requires the GSEs to report the likely cause of the divergence.

Specific remedies and penalties are necessary

Investors may need the FHFA to clearly describe required regulatory actions to remedy misaligned speeds, the time frame a speed differential mightd be tolerated and the penalties that might be assessed if a GSE fails to remedy a problem. The current regulators and GSE management might have the best intentions, but future personnel could view the importance of prepayment speed alignment differently. Committing to specific remedies makes it more difficult for future regulators to deprioritize speed alignment and builds market confidence.

Conclusion

The experience of prepayment speed alignment over the last few years demonstrates how much value can be created by removing this source of risk from prepayment speeds. Allowing that risk to seep back in after single security goes live could undermine confidence. The possibility that speed differences could arise has the potential to hurt TBA execution. The FHFA should take additional steps to convince investors that prepayment speed alignment is durable after single security is implemented.

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