Last week, Freddie Mac said no to the Bond Market Association's (BMA) appeal - on behalf of the dealer community, investors and other market participants - to postpone the agency's implementation of the change in its prepayment accounting cycle relating to Gold and ARM PCs.
This change, which is slated to start on July 1, 2001, effectively puts Freddie on the same schedule as Fannie Mae and Ginnie Mae.
The appeal was made for two reasons: to avoid short-term market dislocation and to make sure that dealers would be able to implement the necessary changes in their operations and other systems to reflect the different prepayment cycle.
The MBA recommended to Freddie that it implement its program not earlier than Sept 1, addressing specifically TBA guidelines which are effective for three months. But because Freddie insisted on not delaying its program, by July 1st there are already a lot of forward trades and positions involving Freddie Mac mortgage-backed securities that will be affected by this change.
"Basically what has happened is that by Freddie Mac's decision they have effectively re-priced existing transactions," said George Miller, deputy general counsel at the BMA. "The bonds that people bargained for now have different performance characteristics. Had Freddie Mac specified an implementation date later than July 1st, as we suggested, at least some of this market dislocation would have been minimized."
Aside from the dislocation, market sources say that this creates the impression that Freddie Mac is trying to save money by implementing the program as early as possible at the expense of market participants. Through the program, the agency will be able to cut on the coupon they have to pay bondholders every time a prepayment occurs.
Director of mortgage funding at Freddie, Robert Burns, says that the primary goal of the agency's changing its prepayment schedule is to make it easier for market participants by harmonizing their reporting with Fannie and Ginnie and that cost benefits for Freddie have not really been factored in.
"Depending on the shape of the yield curve, the level of prepayments there may be a benefit to Freddie Mac, but we have not quantified what those benefits would be," said Burns.
He acknowledges that there may be some short-term inconvenience for security holders but, "we tried to make the announcement so that the adverse effects would be as minimal as possible." He added that they even have an operations professional available to assist dealers in operational problems and questions that may arise because of the new program.
Burns pointed to historical experience where Fannie made a similar announcement. In 1993, the agency accelerated its payment schedule on $37 billion in pools backed by mortgages from the agency's portfolio. Fannie only gave security holders less than two weeks notice, as oppose to Freddie's giving the market at least two months to adjust.
"We felt that we're allowing far more time then historical precedent had indicated so I would be hesitant to characterize our announcement as being given on a short time frame," said Burns.
However, despite the effort on the part of the agency to lessen transition pains, many market players are currently feeling pain.
"The change extracts one time pain from current holders of premium pass-throughs and IOs," said Linda Lowell, of Greenwich Capital Markets. She added that the accounting change also raises a number of issues for securities backed in whole or in part by pools that do not fall under the accounting change, including Giants, REMICs, and Strip Trusts.