Freddie Mac has long struggled to compete with larger rival Fannie Mae because the former's mortgage-backed securities trade at a discount to the latter's. Their new regulator may change that.
As government sponsored enterprises operating in federal conservatorship, Fannie and Freddie are, in theory, equally creditworthy. Yet for a number of esoteric reasons, investors treat Freddie's MBS, which Freddie calls "participation certificates" or PCs, as if they are lower-grade bonds than those guaranteed by Fannie. This has forced the smaller GSE to prop up the liquidity and pricing of its PCs to maintain market share.
For several years the Mortgage Bankers Association has been urging the Federal Housing Finance Agency, the GSEs' regulator and conservator, to address this disparity in pricing. The trade group suggested several options. But the FHFA under acting director Edward DeMarco would not take it on.
The new FHFA director, however, had decided this problem can no longer be ignored. In outlining his agenda last week, Mel Watt said Fannie and Freddie should not only continue building the common securitization platform initiated by DeMarco but also develop a common mortgage-backed security.
"Moving toward a single common security will improve liquidity in the housing finance markets," the former North Carolina congressman said during his first major speech. "It would also reduce costs to the Enterprises, particularly Freddie Mac, since Freddie’s securities have historically traded at a disadvantage compared to Fannie Mae."
MBA president and chief executive David Stevens welcomes the new approach by the GSE regulator.
"Clearly a single security is the most optimal outcome," Stevens says. "It could make Freddie Mac far more competitive, which helps everyone in the industry."
Eliminating the premium Freddie pays investors will also "lower interest rates," he says.
One reason that premium exists is because Fannie MBS typically pays investors earlier each month than Freddie. Another is that the greater volume of Fannie issuance gave its paper greater name recognition in the markets, and hence made it a more liquid, easily traded instrument.
Also, "Freddie securities tended to prepay faster historically, in part a function of differences between the two agencies' underwriting guidelines but that has narrowed a lot," says Clifford Rossi, a former Freddie executive who is now a Professor-of-the-Practice at the University of Maryland's Robert H. Smith School of Business.
Lenders would like to see more competition between Freddie and Fannie.
"This difference in relative pricing creates an economic incentive for customers to conduct a disproportionate share of their single-family business with Fannie Mae and negatively affects the financial performance of our business," Freddie says in its 2013 annual report. "In certain circumstances, we compensate [lender] customers for the difference in price between our PCs and comparable Fannie Mae securities."
Watt's initial focus will make the current GSE system more efficient, says Urban Institute senior fellow Jim Parrott.