The Single Security Initiative Follow-Up: Accounting Treatments, TBAs, and More

As of May 7, investors can now exchange eligible securities for Uniform Mortgage-Backed Securities (UMBS). If you have been following the Single Security Initiative, or even if you are looking for more information, this article will help you understand more about how to process such an exchange.

Single Security Initiative Background

Fannie Mae and Freddie Mac (the Enterprises) developed a single, common enterprise mortgage-backed security, the UMBS (also known as the Single Security).

The UMBS was developed under the Federal Housing Finance Agency’s guidance as part of the broader creation of the Common Securitization Platform. The UMBS is issued and administered by Fannie Mae and Freddie Mac’s joint venture, Common Securitization Solutions. Eligible Participation Certificates (PCs), issued by Freddie Mac, can be exchanged for UMBS. This exchange is voluntary. Fannie Mae’s mortgage-backed securities are already fungible with the UMBS and thus no exchange for them is offered.

For answers to frequently asked questions, see our article, FAQ: The Single Security Initiative.

Float Compensation Processing

Most trading of PCs occurs in the to-be-announced (TBA) market, which is forward-settling. Since PCs have a 45-day remittance cycle and UMBS have a 55-day remittance cycle, investors exchanging PCs will be paid a float compensation amount to account for the 10-day difference.

ACCOUNTING TREATMENTS

Freddie Mac and the NAIC have both indicated the preferred treatment of float compensation processing is to exchange the securities and recognize the float compensation payment on the same day, with the book value being reduced across the exchange.

See the Freddie Mac suggested treatment from Freddie Mac and Fannie Mae Single Security Initiative Market Adoption Playbook, Section 7.6, Regulatory Guidance, paragraph 1:

From an accounting treatment perspective, the Enterprises have received guidance from the SEC that it does not object to treatment of an exchange as a minor modification of the existing security. By concluding that the exchange is a minor modification, holders of the security can carry over the basis of their 45-day securities and would recognize the cash payment received as compensation for the 10-day delay in payment cycle as a basis adjustment on the 55-day Freddie Mac security they received. The Enterprises posted the confirmation letter and companion document on their websites.

Regarding GAAP guidance, if you determine this is a minor modification of the security, this processing is in accordance with ASC 310-20-35. The guidance to determine if this is a minor modification is listed in ASC 310-20-35-11.

For insurance companies, the NAIC indicated its agreement with Freddie Mac at the 2019 Spring National Meeting. To learn more about the NAIC’s decision, read the Clearwater NAIC Spring 2019 National Meeting Update Market Insight Paper.

CLEARWATER IMPACT

For Clearwater users, the default accounting treatment will reflect the preferences of Freddie Mac and the NAIC. The float compensation  payment will be marked as “Cash from Corporate Action,” and the basis adjustment will occur as part of the exchange. This means all the differences will be run through suspense balances, and no income will be recognized by default. This default processing was chosen to match the above suggested treatments to limit the income effect of this exchange and the float compensation payment.

Please note, this does not mean the float compensation is not taxable as income, or that Clearwater users cannot have it processed that way. You should consult a certified tax professional to confirm how best to handle this payment. If Clearwater users would like different processing for any part of the exchange, they should speak with their account managers.

UMBS Issuer Obscurity

Prior to the Single Security Initiative, a TBA trade would, by necessity, specify the agency that issued it. Now that Freddie Mac and Fannie Mae have aligned their mortgage-backed securities into TBA-eligible UMBS, the issuer of a given TBA won’t necessarily be known until 48 hours prior to settlement. In this case, it is known as a generic GSE (government-sponsored enterprise) security.

This situation presents a unique problem for any investor with segregated asset accounts, as the concentration for a given agency won’t be known if a new TBA is purchased. There is a chance that an account will not be adequately diversified if it purchases too many TBAs that later are revealed to be issued by a particular agency.

To accommodate this need for data, the IRS stated it will allow investors to elect the usage of the Federal Housing Finance Agency (FHFA) Deemed-Issuance Ratio as described in IRS Revenue Procedure 2018-54. This ratio will be published by the FHFA at least three weeks prior to the affected calendar year, and is based on the ratio of TBA-eligible securities issued by Fannie Mae and Freddie Mac during the 24-month period ending October 31 of the preceding year. This ratio indicates generic GSE securities are issued in part by Freddie, and in part by Fannie, following the applicable ratio.

Note the following quote from IRS Revenue Procedure 2018-54 while  considering if you need to make this election:

A deemed-issuance-ratio election is applicable to all of the electing taxpayer’s generic GSE securities acquired under TBA contracts that were entered into for quarters ending in the year specified in the election and for quarters ending in all subsequent taxable years for which the election is effective.

CLEARWATER IMPACT

Generally speaking, data providers indicate TBAs will reference issuer information and pool numbers as though the issuer is Fannie Mae, up until the date a proper issuer is known. Clearwater will provide the information our data sources specify, and therefore we also expect to reflect issuer details of Fannie Mae until the proper issuer is known.

As the use of the FHFA Deemed Issuance Ratio is an investor election, Clearwater won’t be applying the ratio by default, and our security database will still reflect a single issuer per security. Reach out to your account manager if you would like to make this election, as we will need to collaborate to track the ratio for each security, and any applicable compliance rules (specifically those related to issuer concentration) will need to be rewritten to accommodate this change.

While, by default, Clearwater will update the issuer of a generic GSE to the most accurate information available, once the election to use the Deemed Issuance Ratio is made,  it will remain in effect for applicable securities. This is regardless of the actual issuers of the delivered securities.

Clearwater recognizes insurance clients are more likely to be impacted by this issue due to their need to maintain appropriate diversification for their portfolios. If, for diversification purposes, you aren’t required to differentiate between Freddie Mac and Fannie Mae, this change to how TBA issuers are reflected shouldn’t have a large impact. Generic TBAs should update to the actual issuer 48 hours prior to settlement.

Investor Resources

If you are interested in exercising the option to exchange your 45-day Freddie Mac securities, here are a couple resources you may find interesting.

• The Freddie Mac Cumulative 45-Day to 55-Day Exchange Activity Data File This resource provides a mapping of the 45-day securities to the new 55-day securities available, and, as of this writing, is updated daily. This can be used to identify the securities held in your accounts that are available to exchange.

• The Freddie Mac Float Compensation Calculator This calculator identifies the new 55-day security mirror and displays the currently expected amount of the payment to be received if the exchange were to be processed. Note: The amount of the Float Compensation payment is expected to change over time, as the amount of the payment is based on the most recent Indicative Price Grid. For Clearwater users, please note that Clearwater won’t be confirming the cash payments to the published calculator, but will instead match the cash amount sent by your custodian. This is because the float compensation payable in any individual exchange transaction will be set forth in the exchange confirmation for that transaction.

NOTABLE DATES FOR THE SINGLE SECURITY INITIATIVE

May 7, 2019

Exchange of Freddie Mac Gold PCs open for booking.

May 17, 2019

First exchange settlement and float compensation payment.

June 3, 2019

Indices show UMBS/Supers and the Enterprises will begin issuing new UMBS securities.

June 6, 2019

The first Supers/REMIC FRB will be broadcast.

June 13,2019

First UMBS notification/netting/settlement.