Benefiting Borrowers with a Creative MBS Disclosure Solution

Fannie Mae recently held its fourth auction of labeled single-family social MBS on June 5, 2024. Through the first four auctions, for par coupons we are typically selling pools for almost 0.5% more than we otherwise would have expected for loans of this type. This noteworthy development of the MBS market is worth considering in the context of a recent Fannie Mae working paper (Low Balance Lending Economics: The Role of the Spec Pay-up) that suggests how these auctions are likely to benefit the underlying borrowers, which are identified by the Mission Index™ disclosure solution launched in November 2022.

At Fannie Mae, our mission is to facilitate equitable and sustainable access to homeownership and quality affordable rental housing across America. We provide liquidity to the U.S. residential mortgage market primarily by acquiring loans from lenders across various channels. By serving as a reliable outlet for lenders to move loans off their balance sheet, as well as facilitating hedging and funding activities, Fannie Mae enables lenders to replenish capital so that they can provide mortgages to more creditworthy borrowers than would otherwise be possible.

TBA and Spec Pool Markets
The TBA (To-be-Announced) market is a foundational mechanism that enables Fannie Mae to fulfill this mission. In this market, participants trade TBA contracts, which are forward agreements to buy and sell mortgage-backed securities (MBS) at a later date. These contracts are unique in that the exact securities are unknown at the time of trade but are considered fungible as long as they meet a few basic definitional parameters. A liquid and reliable TBA market creates efficiencies and cost savings for lenders during the origination process, principally through the ability to lock mortgage rates and hedge risk. The benefits of these improved lender economics are passed on to borrowers in the form of lower mortgage rates and insulation from interest rate volatility during loan underwriting.

Due to relatively limited delivery requirements, the MBS that are ultimately delivered into TBA contracts are generally comprised of loans with the least desirable prepayment characteristics. Market participants who desire a more stable prepayment profile than what they expect to be delivered in the TBA market can stipulate their demand for a particular security that is collateralized by loans that meet additional requirements and often pay a premium to do so. These are referred to as specified (or "spec") pools.

In contrast to a TBA contract, a spec pool is an MBS in which the exact security to be delivered is specified at the time of the trade. These pools can be identified using any criteria available in public disclosures (e.g., loan size, state, loan-to-value, FICO) and the groupings are often referred to as "spec stories." Investor appetite determines the nature of spec pools issued and is largely driven by prepayment expectations. Advantageous prepayment behavior may justify a premium (or "pay-up") relative to the generic TBA deliverable. Although these prepayment dynamics are well-known within the industry, the role of the associated pay-ups in facilitating lending to the underlying borrower populations is less well understood.

Low Balance Lending Economics
Fannie Mae's Single-Family Capital Markets and Economic and Strategic Research teams recently published a working paper exploring how these market dynamics impact origination across the loan balance spectrum, with a specific focus on the importance of the spec pay-up. Leveraging unique data, the authors introduce a new methodology that estimates and decomposes lender revenue for Fannie Mae-guaranteed loans.

Using this methodology, the working paper demonstrates that high balance lending is substantially more profitable for originators than lower balance lending when viewed in dollar terms (as opposed to gain-on-sale margin, which is a common lens through which the market evaluates industry profits). All else equal, lenders are thus financially incented to focus on higher balance loans, making it relatively more challenging for lower balance loan borrowers to gain access to credit, particularly in times of limited industry capacity.

In the context of more challenging lender economics for lower balance loans, the paper illustrates the key role played by the spec pay-up as a source of incremental revenue. By making the economics of these loans more viable for lenders, the spec pay-up improves access to credit for these borrowers. Without the spec pay-up, the paper suggests that either these loans would not be originated, additional subsidies would be required to make originating these loans worthwhile for lenders, or lenders would simply charge these borrowers more by increasing the mortgage rate.

In this way, the spec pay-up does more than simply boost lender revenue. We believe it plays a crucial role in making lending to lower balance loan borrowers feasible through the alignment of incentives between borrowers, lenders, and investors.

Anticipated Impact of Fannie Mae's Social Bond Program
Since the launch of Fannie Mae's Social Bond Program in March 2024, Fannie Mae's Whole Loan Conduit (WLC) has conducted monthly auctions of spec pools flagged with social labels and defined by their High MDS (Mission Density Score) and MCS (Mission Criteria Share). These MBS have consistently received an incremental pay-up at auction over the TBA price, largely due to the fact that historical performance indicates that the underlying loans exhibit superior prepayment performance. The creation of this new specified story was enabled by the introduction of the Mission Index disclosures, facilitating the bifurcation of these loans from the overall pool of generic loans to satisfy investor demand, and enabling incremental value creation from this pay-up.

A major benefit of using the Mission Index is that it effectively mitigates the potential to compromise the TBA market, which establishes the baseline rate for all borrowers, by carefully balancing spec issuance with TBA issuance. If the smooth functioning of the TBA market is found to be impaired by too much growth in the spec universe, rates could increase for all borrowers, and it could become more challenging for lenders to protect borrowers from rate increases during the underwriting process through rate locks. The Mission Index design provides a flexible tool through which such concerns can be addressed.

The emergence of a pay-up for labeled social MBS securities has the potential to improve access to credit for the universe of Mission Index-eligible borrowers in the same way that the low balance spec pay-up supports lending to lower balance borrowers, as demonstrated in the working paper. Lenders may now earn incremental revenue due to investor appetite for high Mission Index loans, which in turn should incent them to prioritize lending to these borrowers.¹ Competitive market dynamics, in turn, should have the secondary effect of putting downward pressure on mortgage rates received by Mission Index-eligible borrowers, as an increasing number of lenders compete to serve these populations.

Through this market-based mechanism that taps into investor preferences, Single-Family Social MBS unlock incremental revenue that can be deployed to benefit borrowers identified by the Mission Index. Within Fannie Mae's Social Bond Framework, Fannie Mae has committed to allocating incremental funds received for labeled social pools in a targeted manner to support mission lending. We expect these funds will primarily be assigned to lenders to improve the economics of mission lending, with any surplus to be deployed in support of targeted affordable programs. We plan to provide annual impact reporting disclosures to provide investors transparency into this dynamic starting in early 2025.

Learn More
Read our companion documents to dive deeper into the Social Bond Framework and Mission Index methodology.

This discussion contains a number of expectations, beliefs and other forward-looking statements, including statements regarding Fannie Mae's business plans, strategies and activities and the impact of those plans, strategies and activities. These expectations, beliefs and other forward-looking statements are based on Fannie Mae's current assumptions regarding numerous factors and are subject to change. Actual outcomes may differ materially from those reflected in these forward-looking statements due to a variety of factors, including, but not limited to, those described in "Forward-Looking Statements" and "Risk Factors" in Fannie Mae's annual report on Form 10-K for the year ended December 31, 2023, and its quarterly report on Form 10-Q for the quarter ended March 31, 2024. Any forward-looking statements made by Fannie Mae speak only as of the date on which they were made. Fannie Mae is under no obligation to, and expressly disclaims any obligation to, update or alter its forward-looking statements, whether as a result of new information, subsequent events, or otherwise.

This discussion is for general information purposes only. This discussion is neither an offer to sell nor a solicitation of an offer to buy any Fannie Mae security mentioned herein or any other Fannie Mae security. Fannie Mae securities are offered only in jurisdictions where permissible by offering documents available through qualified securities dealers or banks.

¹ Pay-ups received by the WLC at auction for specified pools are passed on to lenders for loans eligible for the respective stories, while lenders issuing their own high Mission Index pools will capture the pay-ups directly.