UMBS celebrates its first birthday
admin | June 26, 2020
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.
June 11 came and went this year like any regular settlement day in the agency MBS market. Securities changed hands for cash, TBA contracts rolled to future months and the investors and originators and traders and analysts in the market started thinking about the next day. A year before, the market only hoped for such an uneventful first birthday. The introduction of UMBS in June 2019 marked one of the most ambitious undertakings in MBS market history. A year on, it looks like it has come off without a hitch.
A very, very short history of the push for a single security
Freddie Mac had campaigned since 2012 to create a single security deliverable into TBA MBS contracts. In 2014, Fannie Mae and the Federal Housing Finance Agency joined in. Since the early 1980s, Fannie Mae and Freddie Mac had traded their securities in separate TBA markets. With Fannie Mae since 1990 routinely buying and securitizing around 60% of eligible loans and Freddie Mac taking 40%, Fannie Mae MBS liquidity had made it the market benchmark. Originators and brokers mainly used Fannie Mae TBA to hedge, investors used Fannie Mae for the overwhelming majority of dollar rolls, analysts used Fannie Mae TBA for relative value analysis. In interdealer broker markets, Fannie Mae TBA routinely accounted for more than 95% of contract volumes. The difference in liquidity left Freddie Mac 30-year securities often trading between $0-04 and $0-16 behind fair value, and the enterprise often had to cut guarantee fees to get originators to sell into Freddie Mac. In some years, it cost Freddie Mac hundreds of millions of dollars. And with Fannie Mae and Freddie Mac in conservatorship, that money came right out of the taxpayers’ pocket. A single security would collapse the price difference and increase TBA liquidity.
By September 2018, the enterprises and FHFA announced the Uniform MBS would go live the following June. The enterprises and FHFA in consultation with originators, investors, brokers, data and systems providers and others had decided to keep the Fannie Mae conventions for MBS cash flows and match Freddie Mac to it. The result would be the UMBS. Freddie Mac developed an exchange process and a method to compensate investors for differences in cash flow timing between Freddie Mac PCs and the new UMBS. Systems at originators, brokers and investors would have to recognize the new security. The Internal Revenue Service had to rule that the exchange would not be a taxable event. The Securities Exchange Commission had to rule that an exchange would constitute a minor modification of Freddie Mac securities and not trigger sale treatment or change held-to-maturity status for banks’ and insurers’ securities.
The enterprises could build the UMBS infrastructure, but they could not force investors to drink. Some investors had profited for years on Freddie Mac’s lower security prices or from special dollar rolls created by occasional shortages in Fannie Mae MBS. Others were concerned that putting the two programs together would eliminate incentives to police bad prepayment behavior—to discipline originators that aggressively refinanced their own book, for instance, or to adopt origination, servicing or buyout policies that balanced the needs of both homeowners and investors. Concern from investors about a race to the bottom on prepayment practices had required FHFA and the enterprises to agree to align policies and track and discipline aberrations in prepayments. The alignment agreement persuaded SIFMA to make UMBS TBA-eligible. But the possibility remained that traders and investors would stipulate UMBS-Fannie Mae Only or UMBS-Freddie Mac Only and the markets would still trade separately.
In March 2019, the first UMBS TBA contracts started trading for June settlement. In June 2019, the first UMBS settled.
The results a year later
A year later, price differences between UMBS and Freddie Mac Gold PC TBA contracts largely reflect only differences in the fair value of cash flows (Exhibit 1). Freddie Mac contracts trade at slightly higher prices than UMBS reflecting Freddie Mac’s shorter delay in paying principal and interest. The small gap between TBA PC and TBA PC fair value reflects the small amount of new PCs produced. If Freddie Mac contracts ever fell materially below fair value, investors could exchange PCs for UMBS and arbitrage the price difference.
Exhibit 1: Only small price differences remain between TBA UMBS and TBA PCs
TBA trading volume in Fannie Mae MBS and UMBS has increased over levels before the UMBS launch while trading in Freddie Mac PCs has nearly disappeared. Some of that could reflect the rising balance of outstanding MBS, and some could reflect the heavy prepayments of late 2019 and again since March. Nevertheless, using trading volume as a rough marker, liquidity has at least held and arguably improved.
Exhibit 2: TBA trading volume since the UMBS launch has kept pace or exceeded prior levels
Finally, the volume of Freddie Mac PCs exchanged for UMBS continues to grow. Of the $1.5 trillion in 45-day PCs outstanding in early June 2019, investors have exchanged $368 billion through June this year (Exhibit 3). Another $277 billion of the PCs have prepaid, leaving just $267 billion or 18% in pre-UMBS PCs outstanding and unexchanged. The rest remain tied up in CMOs or the Fed portfolio.
Exhibit 3: Less than 18% of June 2019 PCs remain exchangeable for UMBS
Pricing, trading volume and the steady decline in exchangeable PCs all mark a smooth transition to UMBS. Change in any complex system is hard, especially with so many participants comfortable with the situation as is. The effort on UMBS stands out as a case study so far on how to do it well.