Uniform MBS may prove a two-edged sword for mortgage investors

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The Federal Housing Finance Agency's plan to combine Fannie Mae and Freddie Mac mortgages into a single security starting in June 2019 promises to bring both benefits and challenges to the mortgage sector.

While liquidity and efficiency may get a boost by merging the output of the government-sponsored enterprises, the quality of loans delivered into the new uniform mortgage-backed securities may decline.

The FHFA still has "much more work to do" to convince investors that UMBS will be an improvement, said Walter Schmidt, senior vice president of FTN Financial's MBS strategist team. His concern is that with Fannie and Freddie still independently sourcing the mortgages that go into the single security, price differentials that take into account different prepayment performance of the underlying loans will evaporate.

Investors may see a "race to the bottom" in loan quality because of their inability to price in prepayment speed differentials in the so-called to-be-announced market. Consequently, the UMBS TBA will favor the worst performing loans, as they are the "cheapest to deliver," according to Schmidt. That could hurt lenders, investors and borrowers.

The average swap spread for Freddie/Fannie 30-year 3.5% swap has been about zero for the past two years, according to data compiled by Bloomberg, as their prepayment speeds have converged amid a drop in refinancings. This compares with an average of -6/32 seen during the 2011-2013 period, which saw material differences in their prepayment speeds.

The impending UMBS launch is already mostly priced in to Freddie/Fannie Mae swaps, Morgan Stanley MBS strategists led by Jay Bacow wrote back on April 6, adding that the FHFA's plan will improve liquidity as deliveries are co-mingled.

Kirill Krylov, a senior portfolio strategist at Robert W. Baird & Co., agreed. In an April 19 interview, he said that "in some coupons, Fannie and Freddie can be thin by themselves, but UMBS will beef up liquidity when both GSEs are combined."

"By creating the single securities, the GSEs will erase the pricing differences, thus forcing GSEs to compete for originators on issues such as efficiency and service," he said. "We are very hopeful that this competition will lead to a greater lending efficiency."

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