Freddie Mac's foray into loans to consumers with less-than-perfect credit worries some bond investors and mortgage bankers.
But credit risk is not what bothers the skeptics. They say the inclusion of so-called A-minus loans in Freddie's loan packages will make it harder to measure prepayment risk to purchasers of bonds or of the servicing rights on the loans.
The uncertainty could cause Freddie's securities to trade at a steeper discount to Fannie's, at least temporarily, said John Queen, who helps manage $2 billion of securities at Hotchkis & Wiley in Los Angeles. "Whenever there's a lack of information in the market," he said, "investors demand a premium for that."
The government-sponsored enterprise, based in McLean, Va., began purchasing A-minus mortgages last month, following through on a much- ballyhooed initiative to extend home loans to a wider range of borrowers.
As it does with the higher-quality loans it has always purchased, Freddie will pool the A-minus loans into securities, which it sells in the capital markets.
Investors and lenders are concerned because Freddie Mac plans to mix the A-minus loans with its regular collateral and will not limit how much of the pools can be A-minus loans-or disclose the percentages that are.
"We've never disclosed any credit characteristics and we have no plans to do so right now," said Jamie Miller, director of securities marketing at Freddie Mac. A-minus borrowers have had some delinquency problems in recent years, though not enough to designate them as B and C, or subprime. But like the larger Fannie Mae, Freddie Mac enjoys an implied government guarantee on its loans.
What troubles the critics is the rate at which A-minus borrowers refinance their loans, which they argue is at the very least different from that of mainstream homeowners.
If borrowers refinance their loans faster than anticipated, mortgage securities holders get their principal back earlier than planned and miss out on expected interest payments. A similar problem dogs mortgage servicers, who collect payments and mail monthly statements: When the loans disappear, so do their fees.
"There has been a massive amount of work over the last 10 years to develop good models of prepayments," Mr. Queen said. "Despite that, the models are still awfully imprecise."
By not disclosing the breakdown of the pools, Freddie is exacerbating the problem, he said. "The more you muddy that information, the less your ability to accurately model prepayments."
Freddie Mac argues that investors will be able to infer which securities might have A-minus loans backing them from the average interest rates on the pools.
To be included in a pool, a loan must have an interest rate within 200 basis points of the pool's average. In A-minus loans, "you're starting out with a loan coupon that's 200 to 400 basis points higher than what's being offered to the standard A borrower," Ms. Miller said. Hence, a new security with an average coupon at the prevailing market rate would be unlikely to include any A-minus loans. The agencies originate and securitize very few high-quality loans at above-market rates.
A-minus borrowers' prepayment behavior is driven more by upgrades in their credit standing than by changes in interest rates. For this reason, mixing collateral might be good for investors, said Ignacio Fanlo, a partner at FN Capital, a Rye, N.Y., hedge fund. "You're getting the same return for a more diversified risk."
The Bond Market Association is examining the issue, said George P. Miller, the trade group's deputy counsel.
A-minus loans cost more to service than regular loans. "Identifying such loans for servicing valuation purposes will be difficult and will add inefficiencies to the secondary market for (Freddie Mac) servicing rights," said the chief executive of a top-25 servicer who requested anonymity.
