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Mortgages May Cost Borrowers More Due to Reform Proposal, Pimco Says

  • New security could lead to lower, not higher, liquidity
  • ‘Poorer quality bond’ may cause higher mortgage rates

The proposed Uniform MBS security to be introduced in mid-2019 may increase borrowing costs for the average American and introduce other "significant unintended consequences," Pimco’s Mike Cudzil, Dan Hyman, Kent Smith and Libby Cantrill said in a July 5 interview.

  • Proposed UMBS may engender a "race to the bottom" as Fannie Mae and Freddie Mac start packaging lower-quality securities with impunity
  • See a scramble for older/pre-UMBS collateral that may pressure mortgage rates higher
  • "The intent of issuing a UMBS is to improve liquidity, but we don’t see a mechanism for that and fear that it will make it worse"

Their comments have been edited and condensed for clarity.

Q: The Federal Housing Finance Agency has announced June 3, 2019 as the launch date for a Uniform MBS with the goal of developing "a new securitization infrastructure to improve the overall liquidity" for Fannie Mae and Freddie Mac MBS. Do you believe agency MBS suffer from a dearth of liquidity?

A: The markets for Fannie Mae and Freddie Mac MBS are already some of the most liquid bond markets that exist globally. These markets have never been as deep, liquid or stable as they have been during the GSEs’ time under conservatorship. As such we maintain that the UMBS initiative is no more than a solution in search of a problem.

Further, we believe there is the potential for significantly more downside associated with the UMBS than upside, with significant unintended consequences, including higher borrowing costs for the average American.

Q: The FHFA believes improved liquidity may be attained as "UMBS issued by the Enterprises are designed to be fungible – that is, mutually interchangeable – trading without regard to which Enterprise is the issuer." Do you believe that is the proper route to improved liquidity?

A: We fear that without an explicit incentive to do so, investors will not convert their existing stock of Fannie Mae and Freddie Mac MBS into the new UMBS, thereby leading to a trifurcated market with overall diminished liquidity (old Fannie, old Freddie and new UMBS).

Decreased liquidity is actually something that Fannie Mae identifies as a possible risk associated with the UMBS initiative on page 97 of its 10-Q -- “the Single Security Initiative could contribute to declines in the liquidity or market value of our Fannie Mae MBS.” This is exactly the opposite outcome desired by policymakers.

Q: The FHFA notes that prepayments "are considered by many as key to ensuring the ongoing fungibility of the UMBS." Do you agree with this statement?

A: We do agree yet as currently constructed the FHFA has few tools to ensure that prepayments between Fannie Mae and Freddie Mac MBS are the same – or even similar.

Fannie Mae and Freddie Mac MBS have very different characteristics, including prepayment speeds, and as such typically trade at different prices. Price is an important way for investors to differentiate between Fannie Mae and Freddie Mac, but the UMBS would do away with this important tool.

We believe that without the ability to differentiate on price, investors could see a “race to the bottom” phenomenon in which Fannie Mae and Freddie Mac start packaging worse securities with impunity (i.e., without the usual price mechanism to ensure discipline and accountability). On a broader scale, instead of increasing competition this would dampen it, in our view.

It is inadequate to focus, myopically, on prepayments since in a "race to the bottom" speeds between Fannie Mae-issued UMBS and Freddie Mac-issued UMBS are virtually guaranteed to be similar -- but at a worse absolute level. We expect these worse prepayment speeds will translate directly to higher note rates for borrowers, as all bonds become less valuable and reprice lower.

Accordingly, ensuring alignment is straightforward: mandate the same Selling and Servicing Guides be adopted by both companies with no price differences whatsoever for the acquisition of loans.

Q: Should holders of legacy MBS not swap into UMBS, what problems might that cause?

There is a close market analogue for what is being proposed with UMBS: Freddie Mac’s Gold PC program introduced in 1988. That was an attempt to be more competitive with Fannie Mae by creating securities with superior features, but in the process unintentionally undermined the liquidity of its own market since too few of the legacy bonds converted to the new security.

Compromised liquidity, among other reasons, meant Freddie Mac securities have traded at a discount to (and have sported higher rates than) those issued by Fannie Mae. Consequently, over the years Freddie Mac has spent billions cumulatively in subsidies to induce originators to conduct business with them, leading to reduced profits and less money being swept to the U.S. Treasury Department.

The creation of the UMBS is an attempt by regulators to eliminate price differentials between the GSEs, which in effect would allow Freddie Mac to stop paying the subsidies needed due to the failed implementation of a similar program to UMBS.

A more simple and elegant solution that maintains current liquidity would be for Freddie Mac to simply stop subsidizing the fee. This makes the tax payer better off without the potential market disruptions from UMBS.

Q: Do you believe that as the UMBS launch date comes nearer a spike in volatility for legacy MBS, in particular for coupons of relatively limited float, may impact performance? Do you believe that Gold/Fannie swaps have priced in the impending launch?

We do not expect a significant spike in volatility around the launch date. This has been well advertised and the market has already repriced significantly and will continue to adjust in the months leading into the launch date. Gold/Fannie swaps are already near zero, and the main repricing within the broader asset class will be more gradual.

The area we are most concerned about is the funding market. We believe there is a high probability that there will be scramble for older/pre-UMBS collateral ahead of the launch dates as we believe the UMBS will result in a poorer quality bond. That’s going to shrink liquidity in the funding market, which in turn we expect will pressure mortgage rates higher.

The intent of issuing a UMBS is to improve liquidity, but we don’t see a mechanism for that and fear that it will make it worse.

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