The Fannie Mae-Freddie Mac Single Security Initiative Implementation

NAIC SAPWG Proposal – Limited Scope Exception to SSAP 26R

What is this Single Security Initiative (SSI)?

The Fannie Mae and Freddie Mac enterprises encompass the world’s second-largest bond market and comprise a $5 trillion (yes, trillion) market in bonds guaranteed by the two mortgage finance firms.  The two organizations hold approximately half the U.S. mortgage market. So, to say the least, it’s big, real big.

The SSI is part of a major undertaking to renovate and streamline the general infrastructure of bond issuances of these two massive enterprises.  The SSI goal is to develop a common mortgage-backed security to be jointly utilized by the two entities, with the objective of combining what are now separate TBA (to be announced) bond markets of the enterprises. Currently, the two agencies issue separate mortgage-backed securities with characteristics unique to each issue.  Freddie Mac offers 45-day TBA-eligible and non-TBA-eligible securities contrasted with the Fannie Mae 55-day securities. This has created what some believe is a liquidity anomaly, and has further created a situation where Freddie Mac has been subsidizing the cost of securitizing single-family mortgage loans to offset the trading discrepancy with the Fannie Mae counterpart. The U.S. taxpayer is bearing this subsidization.

To streamline the program and eliminate disparities, each agency will commence issuing a 55-day mortgage-backed security.  It will further ease the transition to a system that will be less dependent on one player in an effective secondary market.  The exchange program is currently slated to commence on June 3, 2019.

So, what’s the rub?

A key component of this change will be an optional offering by Freddie Mac for holders of the existing Freddie Mac 45-day TBA eligible and non-eligible securities.  The option will be provided to exchange those holdings for the newly issued 55-day Freddie Mac counterparts.  For the most part, the new 55-day security received in the exchange will exactly match the components of the security to be exchanged. The cash flows of the 55-day security will ultimately be backed by the same loans as the original security.  Unpaid principal balances, weighted average coupon and pool factors will be mirrored.

How does this affect me as an insurance entity?

The insurance industry is a heavy investment participant in the government-sponsored enterprise (GSE) mortgage-backed marketplace.  It is possible your organization may own some of the affected securities.  Keep in mind the aforementioned exchange is optional.  If, however, your particular program would benefit from making the exchange, you would be interested in how complex the accounting might be for taking on such an endeavor.

NAIC SAPWG transition proposal to the rescue

The NAIC Statutory Accounting Principles Working Group (SAPWG) has contemplated the process, and through INT 19-02, has proposed a simplified accounting approach to the exchange process via a limited-scope exception to SSAP No. 26R – Bonds.

Through its exposure of INT 19-02, the SAPWG has proposed a special circumstance exception to SSAP 26R, paragraph 22.  Under SSAP 26R, the typical method of statutory accounting in an exchange or conversion of a security is to record the cost basis in the new security at the fair market value of security surrendered at the date of the exchange or conversion.  Consequently, if the fair value of security received in the exchange or conversion is clearly more representative of the fair value than the security surrendered, then it can be used as the cost basis for the new security.

INT 19-02 tentatively proposes to make an exception to SSAP 26R, ¶22 by not recognizing the newly exchanged security at fair value but continue to record it at the existing amortized cost basis.  Why?  The thought here is that the newly exchanged security is practically identical to the prior security in form, substance, and make-up.   Accordingly, the effort in time working up fair values becomes more burden than practicality.  This exception would only apply to the SSI program.  INT 19-02 would eventually be nullified at the completion of the SSI exchange (which could take several years).

Any more “gotchas” I should know?

Just one.  As part of the transition process from the 45-day to the 55-day security, investors will receive a one-time recompence that is intended to approximate the fair value compensation for the 10-day delay of the new bond payment.  Basically, this is float reimbursement.  The float adjustment will be treated as a tax-free adjustment by Freddie Mac. Accordingly, INT 19-02 will propose treatment of this float compensation as an adjustment to the cost basis of the security.