A senior Freddie Mac executive suggested today that policymakers consider his company's model for securitizing multifamily loans as they grapple with shielding the government from credit risk while reforming the secondary market. Senior Vice President David Brickman, writing in Freddie Mac's Executive Perspectives Blog, said "K-Deals," is used for almost all apartment loan purchases, the vast majority of which support affordable rental housing. That model could satisfy policymakers' search for a system where private capital bears the risk of most residential mortgages, with the government serving as a backstop only in the case of a major economic catastrophe.
When Freddie Mac purchases loans they are put into diversified pools, and placed into securities comprised of two classes of bonds: guaranteed senior or subordinate bonds and unguaranteed or mezzanine bonds. Private purchasers of subordinate bonds or "B-piece' typically represent the first 7.5 percent of a mortgage pool and are in the "first-loss position" in the event of default If losses exceed that 7.5 percent level, something Brickman calls "unlikely," losses would then be absorbed by holders of the mezzanine bonds, which represent another five to 10 percent of a K-Deal mortgage pool.
The aggregate 15 percent or so of the pool should be sufficient to absorb all the losses if even half of all the loans were to default. (Brickman points out that Freddie Mac's historical average multifamily loss severity over the last 20 years has been 28.7 percent.) These two classes of unguaranteed bonds act like a succession of firewalls: only after losses in the total pool (and not loan by loan) exceed the total amount of subordination in each of the unguaranteed classes would Freddie Mac be exposed to a single dollar of credit loss. "Given that our current loan delinquency rate is just 0.06 percent and our loss rate is a microscopic 0.01 percent, 15 percent is a very big level of protection," Brickman says, "Thus, the senior bonds we guarantee, where the risk is borne by U.S. taxpayers, have so little risk exposure that they, in effect, function more like catastrophic insurance for investors."
This financing structure, unique to Freddie Mac, has financed $60 billion in apartment loans. Even during the height of the financial crisis the multifamily portfolio delinquency rate went no higher than 0.26 percent compared to over 11 percent for privately funded securities (CMBS.) So far this year there have been net credit losses of $3 million on a $130 billion portfolio.
He credits the quality of loan underwriting for the K-Deal success. A new K-Deal is issued about every three weeks and the 80 underlying loans are underwritten, structured, and priced by Freddie Mac staff with oversight from a subordinate bond investor, multiple mezzanine investors, and a dozen or more investors in senior bonds. Investors, including conventional real estate investors, life insurance companies, pension fund managers and major financial institutions, rating agencies, master and special loan servicers, Wall Street analysts, and others also probe Freddie Mac's credit standards, asset quality, and program changes. This collective oversight, Brickman says, instills market discipline and forces the company to continuously improve its securities program in order to continue to finance affordable rental housing.
Prior to 2008 Freddie Mac financed 98 percent of multifamily loan purchases through its retained portfolio, the risk for which was assumed by taxpayers when the company was placed in conservatorship. K-Deals and other forms of securitization supported the remaining two percent. It took just four years to completely reverse these figures, "a testament to our ability to innovate, learn from the capital markets, and implement a completely new business model," he said.
To accomplish this the company looked for ways to marry a CMBS-like structure where it could lay off significant amounts of risk with features commonly found in portfolio lending that provided some flexibility to borrowers. Issuing the first modern K certificate also required significant transformation of infrastructure
The first certificate was issued in June 2009 and 50 more have followed, financing more than two million apartment units and contributing about $5 billion in net segment earnings to Freddie Mac. Brickman said the company has worked to avoid taking advantage of its position as a government-sponsored enterprise, instead trying to establish best practices in mortgage securitization, credit standards, and asset management.
Freddie Mac has transformed the multifamily business from one of a "buy and hold" investor that ultimately placed U.S. taxpayers in a first-loss position to one of a true financial intermediary, making markets and providing liquidity in all economic cycles, Brickman said. "By its program structure, K-Deals offer one proof point that mortgage securitization, if done right, can attract substantial private investment while assuring market support for affordable rental housing."
