Review Of Risk Transfer Efforts By Freddie And Fannie, And A New Approach

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The role of Government Sponsored Enterprises (GSEs) in US housing finance is bigger now than it was in 2008, when the FHFA placed Fannie Mae (OTCQB:FNMA) and Freddie Mac (FHLMC) (OTCQB:FMCC) under conservatorship during the great crisis caused by the decline in U.S. house prices, as the chart below shows. Almost everyone agrees that the housing finance system needs to attract more private capital to protect taxpayers from being on the hook for most of the credit risk being taken in the mortgage market. However, private-label securities market for residential mortgages has not fully revived due to several reasons.

Freddie Mac's K-Deal program has shown a successful method of attracting significant amount of private capital to mortgage market for the multifamily sector. It uses a normal cash senior-subordinate securitization structure but with a unique twist - the K deals issue both guaranteed and unguaranteed bonds. Freddie Mac provides guarantee on the senior bonds only. The program has been very successful[1] in fully transferring the first loss risk of generally over 10% of the loans to private investors.

An ideal structure for the single-family mortgages will be something similar. However, one factor of critical importance in the residential mortgage finance system is the need to preserve the TBA market,[2] which is crucial to smooth functioning of the current housing finance system. TBAs and Pass-Through mortgage pools are fully guaranteed by one of the GSEs, which makes them highly liquid instruments attracting capital to the housing finance system. The GSE guarantee is what makes the residential TBA market work. Without the government guarantee, the TBA markets will not exist. These pools are often securitized by banks in Agency CMO (Collateralized Mortgage Obligation) deals, where all the bonds carry the guarantee provided by GSEs on the underlying pools. However, the need for fully guaranteed pools to allow TBA trading precludes K-deal type securitizations with a mix of guaranteed and non-guaranteed bonds for the single-family mortgages.

When the GSEs issue fully guaranteed single-family MBS, they retain all of the risk associated with losses if the underlying mortgage loans default. Wanting to reduce the credit risk they hold, and encouraged[3] to do so by the FHFA, their regulator, the GSEs have come up with new types of transactions to transfer some of the credit risk of the mortgage loans to private investors. These Credit Risk Transfer (CRT) deals have been very successful with GSEs having completed over $27 Billion of issuance since their introduction in 2013. However, these structures are derivatives and have characteristics that result in only partial transfer of risk and restrict participation from investors like REITs, which limits their growth potential and market size.

This article provides an overview of the CRT deal structures, and suggests a way to allow a K-Deal type structure with a mix of guaranteed and non-guaranteed bonds without disrupting the TBA market.

What are GSE Credit Risk Transfer Transactions?

Freddie Mac did the first risk-sharing transaction, named Structured Agency Credit Risk (STACR), in July 2013, which was followed by Fannie Mae's risk-sharing deal, named Connecticut Avenue Securities (CAS), in October, 2013.

Both of these programs transfer some of the mortgage default risk from GSEs to private investors without impacting the TBA or Agency CMO markets in any way. Mortgages are funded and traded as usual using TBA, Pool, and Agency CMO structures.

The risk sharing is achieved by doing new separate transactions (STACR and CAS), which transfer the risk of default to private investors synthetically by selling a new type of mortgage bonds whose payments are linked to performance of a reference pool of mortgages. The new bonds work just like synthetic CDOs. Investors buy the bonds by paying cash. As loans in the reference pool are paid, the principal balance of the securities is paid back, and if there are losses in the underlying reference pool in future, the principal balance on their bonds is reduced without making any principal payments. Thus they bear the losses as specified by the structure of the CRT deal.

Cash flows of CRT deals are entirely separate from those of the mortgages in the reference pool (which may have been sold as agency MBS securities - securitized as CMOs or as Pass-Through Pools) and mortgage payments are not used to pay holders of CRT debt.

The CRT bonds are not backed by the mortgages in the reference pool and are unguaranteed and unsecured obligations of the GSEs. The coupons on CRT bonds are theoretically paid out of the G-Fee that the GSEs receive for providing the guarantee on the reference pool.

Freddie Mac: Structured Agency Credit Risk (STACR)[4]

Connecticut Avenue Securities (CAS)[5]

Just like in Synthetic CDOs, the new securities allocate the risk of default to different tranches and losses are applied to the capital structure reverse sequentially upon certain credit events. The GSEs typically hold the safest tranche (class A-H) and the riskiest tranche (class B-H). Investors can buy those in the middle (classes M-1, M-2, and M-3) based on their risk and return appetites.

The STACR and CAS are generally similar in most respects though there are some differences in detail. For example, both use a pro-rata payment structure between the senior (A-H) and junior portions of the pool, and sequentially within the junior tranches. Both the Fannie and Freddie deals contain trigger language that dictate the allocation of unscheduled principal to the classes of the deal. Both the Fannie and the Freddie deals have a Hard Enhancement Trigger, e.g. part of unscheduled principal payments is only diverted to the M-1 and M-2 if the enhancement level on the senior is above 3%, which will lock out both STACR and CAS in higher loss scenarios. However, the Freddie deals also contain a Cumulative Loss Trigger, which if tripped, will stop diversion of principal to the M-1 and M-2 classes.

These transactions have been successful. As of March 2016, Fannie Mae has completed 10 CAS transactions issuing $12.9 Billion notes covering 2.5% of the $513.6 Billion reference pool, which represents 18.3% of its total outstanding single family guarantees, while Freddie has done 19 STACR transactions, issuing $14.2 Billion notes covering 3.0% of $468.2 Billion reference pool, which represents 27.54% of its outstanding single family guarantees.[6]

Hedge funds and money managers have made up the bulk of the earliest investors, with REITS, banks and insurance companies participating to a lesser extent.

Also, the deal structures have been evolving since their introduction in 2013. For example, while the early deals focused primarily on loans with very low loan-to-value (LTV) ratios, recently deals have also included mortgages with LTVs over 80%.

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