After years of planning, the two government sponsored enterprises (GSEs) Fannie Mae and Freddie Mac launched their uniform mortgage-backed security (UMBS) in early June. So far, the Urban Institute (UI) likes what it sees.  UI analysts Karan Kaul and Laurie Goodman say the early reaction of investors to the new instrument is encouraging.

The UMBS is actually issued by the common securitization platform (CSP) which was developed jointly by the GSEs under the direction of their conservator and regulator the Federal Housing Finance Agency (FHFA).  The security is backed by mortgages guaranteed by one or the other of the GSEs.  Prior to the advent of the new security, each of the GSEs issued their own securities, each with its own securitization practices, terms, and prices. This was a situation that tended to disadvantage Freddie Mac.

The authors say that investors in mortgage-backed securities (MBS) strongly favored Fannie Mae's security, making it more liquid and more valuable than the one issued by Freddie Mac.  "When selling securities into the market, lenders received a better price for Fannie's securities, even when the loans underlying both securities had identical attributes."  In order to compete, Freddie had to compensate lenders for the difference which could cost them hundreds of millions of dollars a year.  This reduced the company's profitability and thus, under the contractual dividend arrangements with Treasury under which both companies labor, has meant less money going to the taxpayer from Freddie Mac. The UMBS was created to eliminate this imbalance.

The transition to the single security was essentially a transformation of a $5 trillion financial market, therefore its actual launch had to be flawless.  Karan and Goodman say that it was.

Both the GSEs continue to issue their own securities but each can now be delivered into a single security, eliminating the liquidity differences between them. Further, each company's security instrument can be resecuritized into the other company's pool and these pools are also deliverable into the UMBS.  In order to have this mutual deliverability the securities must have identical disclosures and payment delays and be strongly aligned in policies affecting prepayment speeds.

Early data on the launch indicates that investors are reacting well to the new instrument.  The average daily trading volume for agency MBS (which includes the UMBS) was $ 267 billion in June compared to $250 billion in April and $232 billion in May. In addition, there was no decline in MBS pricing which could be attributed to the new security. The conversion of legacy Freddie Mac securities which is necessary to align payment delays before they can be delivered into the UMBS is proceeding apace; close to 10 percent had been converted by early July. Karan and Goodman say that, while it is still early, it appears the launch has gone very smoothly.

In addition to addressing the imbalance between the appeals of the GSEs' securities, the single security is a necessary step for the move to either a single guarantor or to multiple guarantors.  Since both have their advocates should finance reform ever get done, this too is a win for the launch.  The authors say that reducing the competitive advantage Fannie Mae enjoyed over its sister enterprise opens the way to additional competitors over time.  "It is still difficult to imagine how a new entrant would overcome the legacy players' enormous liquidity advantage but moving to a single security helps ease that barrier."

It doesn't eliminate that barrier, however.  The CSP was designed to handle a relatively narrow range of administrative functions for the GSEs. To become a utility that would help other guarantors enter the market it would need to expand not only the guarantors it can support but also the functions. A truly uniform security requires not only consistent securitization practices which CSP does facilitate, but also substantial alignment with the credit underwriting, servicing, and loss mitigation policies that collectively determine how loans perform and prepay.

The GSE's maintain dozens of sophisticated systems to automate the home evaluation process and assess credit risk and have aligned these processes, due to the insistence of FHFA, throughout their conservatorship. Any new guarantor would have to either develop new systems or acquire them from the GSEs which are aligned with the current systems and policies in order to capture investor acceptance. This would be the case regardless of the number of guarantors.

The authors conclude that the UMBS launch is an important step. "It not only removes an expensive inefficiency in the current system, but it also lays the groundwork for deeper structural reforms in the years to come."