Freddie Mac disclosed recently that to support Gold/Fannie Mae swaps, it will be selling FNMA passthroughs from its retained portfolio. The purpose of this move is to fund the purchase of Golds. Freddie will also be buying and selling other agency securities.

Freddie also implied that it would implement a small, albeit significant, adjustment in the operating procedure of its retained portfolio. This shows the GSE's willingness to give up some short-term profit and support the insurance side of its business, researchers stated.

In research written soon after Freddie's announcement, JPMorgan Securities surmised that reimbursing originators for the difference in execution between Golds and FNMA would be very costly for the company. This is because guarantee fees are only in the 12 to 16 basis points range while the execution difference between Golds and FNMAs is worth roughly six basis points.

"We believe that this renewed commitment to gain market share will be partly successful," JPMorgan analysts wrote. Freddie's retained portfolio has about $100 billion in FNMA securities, and it is unlikely that FNMA will sell Golds to buy the more costly FNMA securities, analysts noted.

Reaction to the move has been somewhat muted. Art Frank, head of mortgage research at Nomura Securities International, believes that it is going to be Freddie's purchases over time that will lead to an improvement in pricing. In terms of 5.5s, the predominant coupon originators are currently selling, Golds were priced even to Fannies, Frank said last Thursday. At the end of the prior week, Gold 5.5s were trading three ticks behind Fannies, thus improving by three ticks.

Frank explained that, theoretically, Gold 5.5s should trade five ticks ahead of Fannies because Golds pay on the 15th of the month while Fannie pays on the 25th of the month. This won't happen anytime soon though, he said. "I think Freddie's goal is to narrow the spread gap with Fannie," said Frank. "It's probably not realistic to think that they could totally close the gap."

JPMorgan said that some investors and dealers are worried that because of recent management changes at the GSE, it might take some time before Freddie Mac's portfolio can implement the strategy.

"We believe that investors should cover Gold underweights at current levels," wrote analysts, adding that Gold/FNMA 5 and, to a lesser degree, 5.5s swaps seem attractive. "Given the changes in management at Freddie Mac, we take the renewed emphasis on market share very seriously," they stated.

Representatives from Freddie said that this is only part of a whole game plan, which includes lowering guarantee fees to provide better execution for lenders, as well as diversifying the mix of lenders and products that the company uses so that prepayment on its securities will be more in line with market averages.

"This is one piece of our strategy to improve Gold PC prices," said Freddie spokesperson Douglas Robinson on the GSE's most recent announcement. "We have been talking about this and have been doing different things since early summer."

Why the differential?

Nomura's Frank believes there are three basic reasons why Gold/FNMA price spreads favor the latter.

The first is that Golds have slightly poorer liquidity than FNMAs. FNMAs' slightly better liquidity makes them attractive for large trades with short holding periods, specifically for hedge funds that are in and out of the market quickly. FNMAs trade outright in the inter-dealer broker screens while Golds and GNMAs tend to trade on swap to FNMA. This creates a small difference in liquidity, which is enough for the most active trading accounts to prefer FNMA.

The second reason is the prepayment differential between Golds PCs and FNMA securities, especially in premium coupons. Golds have been prepaying faster compared to their FNMA counterparts. Frank noted, however, that the differential has narrowed in the last couple

of months.

The third reason, although not a significant one, is the negative headlines about Freddie. Fannie has received its share of negative publicity recently, though Frank said that some view Fannie as the better bet, especially those outside the U.S.

A low-key change

In a recent report by UBS, the more significant news in Freddie's announcement was the "subtle change in operating procedure." Despite the fact that both Fannie and Freddie portfolios have traditionally been opportunistic, Freddie was believed to be more so. Freddie's statement implies that the GSE will, on occasion, buy mortgages when it is not exactly economically advantageous, just to support the price spreads.

"They clearly view a price spread correction as crucial to the future success of their business," wrote UBS. "And the thought is that if Freddie is in the market on a more consistent basis, then the price spread will not get as out of line."

The extent to which Freddie changes its operating procedure remains to be seen. This will depend on Freddie's vigilance about defending the price spreads. UBS expects more limited action from Freddie, with the GSE just stepping in when their price spreads become significantly cheap. "So while this may marginally reduce the variability of Freddie Mac's portfolio growth, it is not likely to have a huge effect," wrote analysts.

The liquidity factor

The Gold/Fannie relationship may benefit from the improvement in less liquid trades, UBS said. It a known fact that there are considerably fewer Golds available to trade compared to FNMAs, making Golds harder to short.

Though the liquidity differential makes it harder for Gold/Fannie relationships to consistently trade at full parity, the market is improving for less liquid product, said analysts. The logic is, with most liquid mortgage remaining so rich, buysiders are starting to look at less liquid alternatives. "We have seen a tightening of Golds versus Fannies, as well as a tightening of Jumbo and Alt-A versus Agency paper in both the fixed and hybrid arenas," wrote UBS. "Freddie's actions may speed the narrowing of the Gold/Fannie differentials."

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