By the Numbers

Proposed GSE liquidity rules could raise MBS repo cost

| February 12, 2021

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 face a set of new rules proposed in December that could increase the cost of financing MBS using repo transactions. The new rules, proposed by the Federal Housing Finance Agency, their regulator, would significantly limit the GSEs’ ability to finance cash positions using MBS repo, and this could raise the cost for investors that use repo transactions to finance their MBS positions. Spreads have already widened even though the rule is not finalized and will not be effective until September 2021, possibly because the GSEs have already scaled back their involvement in the market.

The FHFA has long required the GSEs to maintain a portfolio of high-quality liquid assets to protect their ability to serve the mortgage markets during periods of financial stress. But FHFA is proposing to exclude agency MBS and agency MBS repo transactions from the list of allowable investments. It is important that the GSEs can provide liquidity to markets during periods of stress. The GSEs could exacerbate a liquidity crisis if they also needed to sell MBS to raise cash.

It is believed the GSEs have been heavily involved in agency MBS repo transactions. Each month servicers remit scheduled principal and interest and principal from prepayments to the GSEs. The amount cash can be very high. It averaged $85 billion a month from 2014 through 2019 and jumped to roughly $170 billion in 2020 due to fast prepayment speeds. This cash is held for roughly 10 days before it is paid to MBS investors. The GSEs can invest this cash during that period, and it is believed they often bought agency MBS in repo transactions.

The liquidity requirements need to be calculated each day. Once the GSEs receive the principal and interest payments, their liquidity needs will jump due to the upcoming payments to MBS investors. That will force most, if not all, of the cash received to be invested according to the liquidity portfolio’s rules. Fifty percent are required to be invested in Treasury debt or held in cash at the Fed. Under the proposed rules the remaining fifty percent can also be used for Treasury repo transactions and a limited amount in unsecured overnight deposits with eligible U.S. banks. But agency MBS and agency MBS repo are no longer permitted.

The new rules also increase the amount of liquid capital the GSEs are required to hold. The amounts are calculated under various stress scenarios. For example, they assume the GSEs are unable to raise cash by issuing debt, that mortgage delinquencies increase, and that the five largest non-bank servicers fail to remit timely principal and interest. They will also need to carry a $10 billion excess to cover any errors and other unforeseen shortfalls. Although the FHFA notes that the GSEs currently “meet or exceed all requirements of the proposed rule,” it seems unlikely that the GSEs will have much cash to invest in MBS repo after meeting their liquidity requirement. MBS investors should find that the cost of repo financing increases as the GSEs exit that market.

FHFA proposed the new rules on December 17 and will take commends until March 9. The FHFA notice of the rules is here.

Brian Landy, CFA
brian.landy@santander.us
1 (646) 776-7795

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