Many of us who grew up as children of children of the Great Depression may recall our parents imploring us to “Stop throwing good money after bad!” in any number of situations, even if we didn’t always heed their wisdom. Economists call this the “sunk cost fallacy” – the tendency of humans and organizations who have invested significant money, time or effort in a particular project to continue to do so even when it no longer makes economic sense.
In our view as investors, the U.S. Federal Housing Finance Agency’s (FHFA) “Single Security” initiative is emblematic of a sunk cost fallacy. As the regulator and conservator of Fannie Mae and Freddie Mac (aka the agencies or government-sponsored enterprises or GSEs), the FHFA seeks to improve liquidity in the agency mortgage-backed securities (MBS) market by introducing a unified GSE mortgage-backed security. The FHFA currently plans to introduce Single Security in June 2019.
However, the agency MBS market is already one of the most liquid bond markets there is. PIMCO is one of the largest and longest-standing participants in the agency MBS market, and we believe the market has likely never been as deep, liquid or stable as it is now. While we don’t question the good intentions of FHFA policymakers, we do question why they would continue to invest significant resources in an effort where the problem they seek to address is not actually a problem at all.
We also see parallels between Single Security and another investing phenomenon: “negative convexity.” When a bond has negative convexity, as can often happen in the MBS market, its price tends to fall further in rising interest rate environments than it goes up when rates decrease. In other words, it is more likely to lose than to gain. Likewise with Single Security, we believe the potential losses – i.e., less access to affordable mortgage credit for low to middle income Americans and lower liquidity that could result from poor implementation – far outweigh any potential gains – i.e., hypothetical enhancements to an already deep, broad and liquid market.
This looks all too familiar
There is historical precedent for our concerns about today’s Single Security initiative. In the 1990s, Freddie Mac introduced the Freddie “Gold” security, which was designed to both remedy a competitive market share problem Freddie Mac suffered relative to Fannie Mae and increase liquidity – the same goals as today’s Single Security initiative. Instead of achieving its stated objectives, however, the Freddie Gold securities merely fragmented the market and actually reduced liquidity for decades. (For details, please see our Viewpoint, “Higher Mortgage Rates Are Likely With Proposal of ‘Single Security.’”)
We believe Single Security’s implementation could hurt markets and investors by jeopardizing the liquidity of both Fannie and Freddie securities. Further, we believe Single Security raises risks across the entire secondary mortgage market, with potentially serious consequences for mortgage borrowers and taxpayers.
In our view, the GSEs have satisfied their charter mandate: They have provided stability in the secondary market for mortgage securities. The Single Security initiative, logically and by precedent, puts that stability at risk. We note that one of the FHFA’s goals of conservatorship is to enhance the GSEs’ capacity to fulfill their mission. Single Security, in our view, is much more likely to do exactly the opposite, while continuing to throw good money after bad in the process.
For more of our views on housing finance and the U.S. mortgage markets, please see “U.S. Housing Finance Reform: Why Fix What Isn’t Broken?”
Libby Cantrill is PIMCO’s head of public policy and a regular contributor to the PIMCO Blog. Mike Cudzil is a portfolio manager on the liability-driven investment team, Daniel Hyman is co-head of the agency mortgage portfolio management team and Kent Smith is a portfolio manager on the mortgage credit team.