The ASF recently released a white paper entitled "Discussion of a Proposed Single Agency Security" that outlines the issues to be addressed in effectively merging the securities markets of Fannie Mae and Freddie Mac to reduce "TBA market inefficiencies." This column will discuss the implications of unresolved issues raised by the report.

The underlying objective of creating a Single Agency Security (SAS) is to mitigate the pricing disadvantage that severely hinders Freddie Mac's ability to price and securitize loans. While they should trade at a premium to Fannies (due to the reduced payment delay), Freddie Gold pools have traded at an increasingly large concession to Fannies. As the paper discusses, this translates into a loan pricing disadvantage that has pushed the bulk of new originations to Fannie, forcing Freddie to offer lower guarantee fees and other concessions in order to remain competitive.

In examining the creation of the SAS that will replace separate Fannie and Freddie issuance, there is a general consensus on a number of issues, including standardized pooling and delivery practices and loan underwriting, servicing and repurchase policies. The two remaining areas of contention are whether the enterprise issuing the pool will be identifiable by investors, and whether the two enterprises will be required to offer the same guarantee fees.

Investors' desire to know the issuer of a particular pool is understandable, mainly due to credit-related issues (which will become increasingly important once the Treasury's unlimited support of the GSEs ends in 2013).In my view, market efficiency and transparency are intrinsically related. Moreover, attempting to hide the issuer will only create incentives for investors to try to obtain or deduce the information, unnecessarily incenting bad behavior; it's easy to imagine enterprising young traders trying to contact originators in order to obtain non-public information. (As the LIBOR scandal demonstrates, if an action is potentially profitable, someone will eventually try to do it.)

The other issue pertains to whether guarantee fees should be standardized, or whether originators should continue to "face" Freddie and Fannie separately. Assuming that mandated g-fees would pass Justice Department scrutiny, a critical question is whether different guarantee fees will actually impact long-term prepayment behavior. There is validity to the argument that the enterprises' prepayment speeds will eventually diverge if g-fees and, by implication, loan prices are materially different. This will in turn impact loans' securitized execution, as prepayment differences will ultimately be reflected in the market pricing of the SAS.(TBA markets trade based on the security that is cheapest to deliver.) Assuming that other operational aspects of the two enterprises' operations are standardized, however, I believe that prepayment speed differences will be largely attributable to WAC differentials. This suggests that enterprise-specific prepayment differences can be modeled; in addition, a specified pool market for low-WAC pools will develop if a measurable prepayment advantage is detected. If an exogenous prepayment difference eventually develops, however, investors will be able to better respond if the enterprise guaranteeing the security is identified.

In addition, the g-fee discussion overlooks the fact that buy-down multiples (which dictate the price at which each enterprise will monetize some or all of the g-fee) also profoundly impact loan pricing, especially as g-fees increase. Therefore, both variables would need to be controlled in order to assure equivalent pricing. Consumers will also benefit from a healthy competition between the two enterprises, especially given the dearth of securitization alternatives. Finally, the white paper does not address how pricing variables will be set, raising a host of regulatory and operational issues. Taken together, these considerations suggest that allowing the enterprises to separately determine their pricing is the best solution.

 

Bill Berliner is Executive Vice President of Manhattan Capital Markets. He is the co-author, with Frank Fabozzi and Anand Bhattacharya, of the recently- released second edition of Mortgage-Backed Securities: Products, Structuring, and Analytical Techniques. His email address is bill_berliner@manhattancapitalmarkets.com.

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