Preparing for the Single Security Initiative – Analyzing Prepayment Alignment

The upcoming implementation of the Single Security Initiative makes it critical for mortgage market participants to have appropriate tools for analyzing and monitoring the prepayment behavior of Agency MBS. RiskSpan’s data and analytical platform, RS Edge, allows mortgage market participants to ‘dig deeper’ into the drivers of prepayment behavior for Agency MBS and will help identify trends when prepayment behavior is not aligned with UMBS issued by Fannie Mae or Freddie Mac beginning in June 2019. 

On June 3, 2019, Fannie Mae and Freddie Mac will begin issuing passthroughs under the Single Security Initiatives Uniform Mortgage-Backed Securities program (UMBS).1 The Single Security Initiative marks one of the most significant changes in the Agency-backed passthrough to-be-announced (TBA) mortgage market and will forever change the dynamics of one of the most liquid fixed-income markets in the worldThis change was engineered by the Federal Housing Finance Agency (FHFA), the regulator for Fannie Mae and Freddie Mac, and has been in the works since 2014The Single Security Initiative is a joint initiative implemented by Fannie Mae and Freddie Mac to develop a common residential mortgage-backed security. The objective is to unite the separate TBA markets for Fannie Mae and Freddie Mac – currently $2.4 trillion for Fannie Mae and $1.1 trillion for Freddie Mac – into one larger, more liquid market. 

With the implementation of the Single Security Initiative, passthroughs issued by Freddie Mac and Fannie Mae eligible for delivery into TBA trades will have consistent payment delays (deliverable Freddie Mac passthroughs will move from a 45-day payment delay to the 55-day payment delay)identical naming conventions, and similar prepayment profiles. In practice, new Freddie Mac passthroughs will be issued under the terms currently used by the Fannie Mae program. Passthroughs from either Freddie Mac or Fannie Mae will trade in a single TBA market and will be referred to as UMBSThe Single Security Initiative will create a consistent, fungible UMBS for fixed-rate 30-, 20-, 15-, and 10-year mortgage pools guaranteed by either GSE.  

Upon implementation, mortgage market participants will be able to trade UMBS with consistent terms and conditions, irrespective of which entity (Freddie or Fannie) issued the securityThe movement to the UMBS will provide a number of benefits to the mortgage market, including: 

  • Increasing the outstanding volume of a single, consistent TBA mortgage market as the securities from both Fannie Mae and Freddie Mac are created under the same “good-delivery” terms and conditions, 
  • Reducing or eliminating the subsidy paid by Freddie Mac to capture market share from Fannie Mae due to the beneficial pricing enjoyed by Fannie Mae MBS in the current, bifurcated TBA market, and 
  • Creating an infrastructure that may support additional guarantors competing alongside Fannie Mae and Freddie Mac.2

Given the benefits associated with these enhancements to the TBA mortgage market, FHFA assumed that market participants would achieve consensus for the initiative. However, market participants have expressed concerns about the ability to maintain prepayment behavior alignment between Fannie Mae- and Freddie Mac-issued UMBS. While this is not the only challenge that must be overcome for a smooth transition, it is significant one. Lack of prepayment alignment could eliminate some of the benefits of the UMBS program. To address this concern, FHFA actively monitors prepayment performance of passthroughs issued by Fannie and Freddie and publishes a set of quarterly performance reports3These reports provide market participants with additional transparency on prepayment behavior alignment and allows the FHFA to monitor and address differences in conditional prepayments rates (CPR) between the two issuers. 

On February 28, the FHFA issued its final rule on UMBS. As part of that process, the regulator indicated certain key changes related to UMBS pooling requirements and its monitoring of prepayment behavior between Fannie Mae and Freddie Mac. In the final rule, FHFA addressed the following key updates: 

  • Pool eligibility requirements for all fixed-rate products will be modified such that the note rate on any mortgage in a pool backing a given security cannot be more than 112.5 basis points greater than the coupon on that security.  
  • UMBS Cohorts, defined as all TBA-eligible securities with the same coupon, maturity, and loan-origination year where the combined unpaid principal balance of such securities issued by both Fannie Mae and Freddie exceeds $10 billion, will be monitored to identify instances in which prepayment speeds between the GSEs diverge by more than: 
    • 2 percentage points for 3-month CPRs of each cohort, or  
    • 5 percentage points in the fastest paying quartile for each cohort. 

RiskSpan has played an integral role in the UMBS standardization process by providing the prepayment monitoring reports to FHFA using RS Edgeits data and analytics platformThese prepayment reports enable the regulator to enforce standards and proactively monitor ongoing behavior to address concerns before they breach the thresholds above. As a leading provider of data and analysis solutions to the mortgage market, RiskSpan has developed RS Edge to support the creation of user-defined, multi-layered queries, which gives subscribers the ability to ‘slice-and-dice’ on any pool or loan characteristic. This allows users to identify and analyze emerging prepayment behaviors of either Fannie Mae or Freddie Mac, or both agencies together, a crucial feature for the new TBA UMBS marketThe platform enables market participants to analyze the publicly available prepayment data published by Fannie Mae and Freddie Macboth as a pool and at loan levelto analyze differences in prepayment behavior between the Agencies and the collateral characteristics that may lead to divergences in prepayment behavior. 

The following example illustrates how easy RS Edge makes it to identify differences in both prepayment and collateral characteristic trends.   

The figure below plots CPR against refinancing incentive for Fannie and Freddie loans, for borrowers that would typically be excluded from a pool that trades at a pay-up over TBA (“ex spec pool”). In this plot, we filter for loans with loan size greater than $200,000,4 FICOs above 700, LTV < 80%, and excluding loans from New York and Texas. As illustrated, Fannie and Freddie speeds closely align for this “non-spec” sector for refi incentives -100bp to +100bp. But when refi incentive grows to +125bp to +150bpFannie non-spec loans pay approximately 2 CPR faster. While these deviations are within FHFA’s tolerance, it may mean that Fannie-issued pools are marginally more likely to be delivered than Freddie pools for in-the-money coupons, all else equal. 

CPR by Refinancing Incentive, FNMA loans (black) versus Freddie Mac (blue) 

Notwithstanding the common UMBS platform, the potential number of subtle permutations that could cause the Agencies’ prepayment speeds to diverge is nearly limitless. RS Edge is the key to drilling down into these differences and making sense of the data that drive them.   

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Footnotes

[1] We expect forward trading to begin one to two months prior to the UMBS go-live date.
[2] As of this report’s date, FHFA has cast doubt on whether any other guarantor will use the UMBS framework going forward. However, this remains an option.
[3] RiskSpan generates these FHFA reports, including data and calculations, via our interactive data engine called Edge. Contact RiskSpan for more information on Edge.
[4] Including loans above the conforming loan size limit but excluding Jumbo pools. This allows Jumbo loans that are in deliverable pools into the sample.