Wanda DeLeo, Deputy Director of the Conservatorship Division of the Federal Housing Finance Agency (FHFA) told a Senate Banking Committee hearing that the new profitability of Freddie Mac and Fannie Mae (the GSEs) "should not blind us to the very real costs associated with their failures." The dividends the two have paid to the Treasury, she said, reflect not a return of capital, but payment for the extraordinary risk the government was forced to take in saving them.
It is in keeping with FHFA's responsibilities as conservator to minimize taxpayer risks while ensuring the operation of the secondary mortgage market. "At the same time, standards, norms, and private investment capacities are needed that can continue under a new secondary market structure," she said. "Credit risk transfers can help us simultaneously in all three of our broad conservatorship goals: build, contract, and maintain," and accordingly FHFA has set a target for each of the GSEs to carry out a minimum of $30 billion in risk sharing transactions this year.
The initial focus has been on two broad categories of risk sharing, pre-funded capital markets transactions, and insurance or guarantee agreements. The former includes Freddie Mac's Structured Agency Credit Risk securities (STACRs) and Fannie Mae's Connecticut Avenue Securities (C-deals) under which investors buy debt securities that offer relatively higher returns when credit performance is good but may lose principal when credit performance deteriorates. The insurance or guarantee agreements are ones in which an insurer pays claims in the event of loss.
In both types of transactions, the Enterprises essentially use a portion of their guarantee fee income from the reference pool to purchase credit protection, either through higher interest rates paid on the capital market transactions, or though premiums paid to insurance companies.
This year, each GSE has sold debt securities that transfer to private investors a portion of the credit risk of a large reference pool of single-family mortgages that the Enterprise had previously securitized. Freddie Mac has completed two STACR transactions to date, and Fannie
Mae has completed one C-deal. Each transaction provides credit protection to the issuing GSE by reducing the principal on the debt securities as credit performance of the reference pool deteriorates.
Both the STACRs and C-deal were issued as senior debt of Fannie Mae or Freddie Mac and investors can rely on the GSEs' special credit standing and the backing of the Treasury as comfort the payments to investors will occur. But part of the purpose of these transactions is to develop standardized credit risk investments that could be sold in the future by securitizers other than the GSEs.
The GSEs ultimately hope to issue notes through bankruptcy remote trusts that would have the same economics for investors, but a legal structure independent from the GSEs credit standing, relying on the trust managing the proceeds from the note. This eventuality has raised a number of questions that FHFA is working with other agencies to resolve but statutory clarifications might be helpful. DeLeo said FHFA is working with the Committee staff on possible solutions. She noted that all of these structures would be ineligible for REMIC tax treatment but obtaining that treatment would significantly expand the investor base.
Both Enterprises have also completed insurance transactions this year as well. In October Fannie Mae executed a pool insurance policy with National Mortgage Insurance (National MI) which transferred a substantial portion of the credit risk on a pool of single-family mortgages securitized by the Enterprise in the fourth quarter of 2012. In November Freddie Mac executed a transaction that transferred to Arch Reinsurance, a global reinsurer, a portion of the residual credit risk that the Enterprise had retained on the reference pool of mortgages underlying the first STACR transaction.
Each of the risk transfer models under which the GSEs have executed transactions has inherent strengths and weaknesses. From a GSE perspective, the sale of securities provides upfront funding of credit risk without the counterparty risk inherent in transferring credit risk. This approach offers efficient, competitive, market pricing of risk, spreads risk across many investors with varying degrees of leverage, and with varying degrees of risk concentration in mortgages. A possible downside is that overreliance on this approach may leave the market for risk more prone to price change in response to changing market conditions.
From an overall housing finance system perspective, the leverage of participating investors in capital markets transactions may not be regulated, presenting significant variation in the amount of equity capital deployed to bear credit risk and capital markets funding sources maybe more volatile over the credit cycle. Transferring risk to the insurance sector allows for monitoring of financial strength and leverage either by the market or through regulatory requirements. The potential differences in the leverage under the two models also have implications for their relative cost. FHFA and the Enterprises will continue to assess those strengths and weaknesses, DeLeo said.
Under reinsurance the GSEs can take advantage of the firms' mortgage expertise and dedicated capital and they may be less quick to leave the market during a temporary market disturbance, especially one not directly related to housing markets. However, this approach involves more counterparty risk, more vulnerability to housing market weakness when the counterparties are not diversified, and a more limited set of bidders for the risk.
Another potentially powerful means of risk transfer is use of senior/subordinate security structures. The GSEs have made progress in considering how such structures might work and are grappling with many of the problems faced by private label securities issuers such as: due diligence, representations and warranties, dispute resolution, and the role of trustees. If good solutions can be found for past problems, this approach may be easier than some others for non-GSE issuers to adopt. A disadvantage to transferring losses on a small pool of mortgages in a cash transaction, rather than on a large reference pool in a synthetic transaction or insurance agreement, is that credit evaluation costs can be considerably higher, as investors must consider the idiosyncratic risks of a particular small pool, rather than those of a cohort diversified by geography, lender, and sheer size. Considering ways to develop more standardization and liquidity in this market could help to address some of these issues.
The transactions considered so far have been GSE-centric in that they depend heavily on the GSE's existing business practices and the familiarity of loan sellers and investors with those practices. There is a need to make these advantages more generalizable such as by arranging for credit enhancements or by outsourcing servicing and loss mitigation to firms specializing in those activities.
DeLeo said the GSEs have made major steps in risk transfer this year and, if sufficiently scalable, they will provide mechanisms to free taxpayers from shouldering almost all the burden of mortgage credit risk and place that risk in the private sector. FHFA will, she said, continue with the GSEs to explore new techniques or variations to find the most workable solutions and those that show the best promise of reducing the GSEs' footprint, consistent with maintaining efficient and effective mortgage markets.
