Though Freddie Mac was embroiled in continuing controversy last week - involving firings of top officials and investigations by the Securities & Exchange Commission and the House Financial Services Committee - MBS players remained unfazed.
In terms of the mortgage market, Merrill Lynch analysts wrote last Wednesday "there has been relatively little impact of the Freddie announcement." The firm added that Gold/FNMA swaps in the lower coupons have fallen 1/32 to 2/32 since Monday without a major repricing.
Merrill said that, all in all, the impact was mostly felt by the equity markets with a lighter impact in the debenture markets, and "only faint echoes in the mortgage market."
The firm added that this makes sense because the mortgages are backed not only by Freddie's guarantee but also by the principal and interest payments of the borrowers.
Art Frank, head of mortgage research at Nomura Securities International, said that the Freddie Mac headlines only slightly affected investors in Gold securities. "Those investors who were long Gold 5s and short Fannie 5s lost about 3 ticks," Frank said last Wednesday. "So that's a small pain, not a huge one." He stated that people should remember that Golds were already cheap against Fannies because of the prepayment differentials before the news about the Freddie management shake-up broke last Monday morning.
He also said that there would likely be more headline risk to come. However, he feels that the impact will only be in the short run. Frank added that there is no reason not to believe that Freddie would be disclosing anything more than a change in the timing of income recognition when it releases properly audited financial reports approved by PricewaterhouseCoopers in the third quarter.
Frank noted that there might be bad news relating to a triple-A entity, even if it does not entail a downgrade. The unfavorable news may still cause spreads on the agency's debt to widen a bit, as it did with Freddie's debentures. This does not really mean there is a significant credit quality issue.
Even before the brouhaha
Other analysts said that the major news about Freddie for the mortgage-backed sector has already been priced in the passthrough market for weeks, long before the management shake-up.
Bear Stearns said last Tuesday that the market is still implying more prepayment and liquidity risk in Freddie passthroughs than it sees in its rival Fannie Mae. The firm stated that Freddie Mac's 30-year 4.5% passthrough closed last Monday at $100:9, which is 3/32s behind Fannie Maes. This is more than 6/32s behind the price warranted by Freddie Mac's shorter delay. "Call it prepayment risk," wrote analysts. "A price concession by any name is still a price concession."
There is also the factor that the most recent prepayment reports were more Gold-friendly compared to last month. Merrill said that this has actually caused higher coupon swaps to improve by 1/32.
Moreover, there were other reasons aside from the negative headlines that contributed to Golds trading behind their Fannie counterparts. Merrill wrote that the dip in the lower- coupon Gold swaps happened in the midst of a market rally, and that Golds have generally been trading to slightly shorter durations than their FNMA counterparts. This differential is due to faster prepayments and the lack of a CMO bid in the higher coupons. The firm also stated that stronger rolls on the FNMA side have also contributed to their better bid, which is separate from Freddie headlines.
It's all about accounting,
MBS market players view the Freddie Mac spectacle as more of an accounting issue than mortgage-backed related.
For instance, UBS Warburg said last Wednesday that increased regulatory scrutiny might be the upshot of the negative headlines. However, any increased regulation would likely tax Freddie shareholders, and the mortgage market would largely remain undisrupted.
"The issues seem to be accounting-related," said an MBS investor. He added that aside from the negative headlines, investors are also taking into account differences in servicer concentration between Freddie and Fannie pools as well faster prepayment speeds on Freddie collateral.
The investor added that buysider confidence was inspired by the appointment of Greg Parseghian as Freddie's new chief executive officer "He certainly has the background and experience to deal with the whole aspect of mortgage portfolio management," the investor said.
This investor's firm bought Gold 5s last Wednesday because they were three to four ticks cheaper than their Fannie counterparts. "It remains to be seen how well that works out," he said. "I am kind of counting on the roll market to support Golds in the not so distant future."
Merrill Lynch was somewhat hopeful about Freddie's prospects. They said that going forward, in the absence of further negative revelations, the Gold/FN current coupon swap should not drop much further. However, they said that the wider Freddie debenture spreads, Parseghian's promotion from chief investment officer to CEO as well as management focus on solving the current crisis could result in slower portfolio growth for the GSE. These might result in less support for Golds in the future.
Bear Stearns was more encouraging. "We are rooting for steady progress at Freddie Mac," analysts wrote last Tuesday. "Despite the market power exercised by the GSEs, which has earned it both admirers and detractors, the market has been well served by two strong conventional agencies."
Bear added that originators, investors and the Street would benefit from an efficient and competitive market for mortgage-backeds. "It is hard to imagine that a weaker Freddie Mac or a weaker position for the GSEs overall would be good news for a smoothly functioning market in MBS," said analysts.