FHFA Tries to Convince Senate that GSE Risks Outweigh Massive Profits

WandarnDeLeo, Deputy Director of the Conservatorship Division of the Federal HousingrnFinance Agency (FHFA) told a Senate Banking Committee hearing that the newrnprofitability of Freddie Mac and Fannie Mae (the GSEs) “should not blind us tornthe very real costs associated with their failures.”  The dividends the two have paid to thernTreasury, she said, reflect not a return of capital, but payment for thernextraordinary risk the government was forced to take in saving them.  </p

Itrnis in keeping with FHFA’s responsibilities as conservator to minimize taxpayerrnrisks while ensuring the operation of the secondary mortgage market.  “At the same time, standards, norms, andrnprivate investment capacities are needed that can continue under a newrnsecondary market structure,” she said.  “Creditrnrisk transfers can help us simultaneously in all three of our broadrnconservatorship goals: build, contract, and maintain,” and accordingly FHFA hasrnset a target for each of the GSEs to carry out a minimum of $30 billion in riskrnsharing transactions this year. </p

Therninitial focus has been on two broad categories of risk sharing, pre-fundedrncapital markets transactions, and insurance or guarantee agreements.  The former includes Freddie Mac’s StructuredrnAgency Credit Risk securities (STACRs) and Fannie Mae’s Connecticut AvenuernSecurities (C-deals) under which investors buy debt securities that offer relativelyrnhigher returns when credit performance is good but may lose principal whenrncredit performance deteriorates. The insurance or guarantee agreements are onesrnin which an insurer pays claims in the event of loss.  </p

Inrnboth types of transactions, the Enterprises essentially use a portion of theirrnguarantee fee income from the reference pool to purchase credit protection,rneither through higher interest rates paid on the capital market transactions,rnor though premiums paid to insurance companies. </p

Thisrnyear, each GSE has sold debt securities that transfer to private investors arnportion of the credit risk of a large reference pool of single-family mortgagesrnthat the Enterprise had previously securitized. rnFreddie Mac has completed two STACR transactions to date, and Fannie</p

Maernhas completed one C-deal.  Eachrntransaction provides credit protection to the issuing GSE by reducing the principalrnon the debt securities as credit performance of the reference poolrndeteriorates.</p

Bothrnthe STACRs and C-deal were issued as senior debt of Fannie Mae or Freddie Macrnand investors can rely on the GSEs’ special credit standing and the backing ofrnthe Treasury as comfort the payments to investors will occur. But part of thernpurpose of these transactions is to develop standardized credit risk investmentsrnthat could be sold in the future by securitizers other than the GSEs.  </p

The GSEs ultimately hope to issue notes throughrnbankruptcy remote trusts that would have the same economics for investors, butrna legal structure independent from the GSEs credit standing, relying on therntrust managing the proceeds from the note. This eventuality has raised a numberrnof questions that FHFA is working with other agencies to resolve but statutoryrnclarifications might be helpful.  DeLeornsaid FHFA is working with the Committee staff on possible solutions. She notedrnthat all of these structures would be ineligible for REMIC tax treatment but obtainingrnthat treatment would significantly expand the investor base.</p

BothrnEnterprises have also completed insurance transactions this year as well.  In October Fannie Mae executed a poolrninsurance policy with National Mortgage Insurance (National MI) whichrntransferred a substantial portion of the credit risk on a pool of single-familyrnmortgages securitized by the Enterprise in the fourth quarter of 2012. InrnNovember Freddie Mac executed a transaction that transferred to ArchrnReinsurance, a global reinsurer, a portion of the residual credit risk that thernEnterprise had retained on the reference pool of mortgages underlying the firstrnSTACR transaction. </p

Eachrnof the risk transfer models under which the GSEs have executed transactions hasrninherent strengths and weaknesses.  Fromrna GSE perspective, the sale of securities provides upfront funding of creditrnrisk without the counterparty risk inherent in transferring credit risk.  This approach offers efficient, competitive,rnmarket pricing of risk, spreads risk across many investors with varying degreesrnof leverage, and with varying degrees of risk concentration in mortgages.  A possible downside is that overreliance onrnthis approach may leave the market for risk more prone to price change inrnresponse to changing market conditions.</p

Fromrnan overall housing finance system perspective, the leverage of participatingrninvestors in capital markets transactions may not be regulated, presenting significantrnvariation in the amount of equity capital deployed to bear credit risk and capitalrnmarkets funding sources maybe more volatile over the credit cycle.  Transferring risk to the insurance sectorrnallows for monitoring of financial strength and leverage either by the marketrnor through regulatory requirements.  Thernpotential differences in the leverage under the two models also havernimplications for their relative cost. rnFHFA and the Enterprises will continue to assess those strengths and weaknesses,rnDeLeo said. </p

Underrnreinsurance the GSEs can take advantage of the firms’ mortgage expertise andrndedicated capital and they may be less quick to leave the market during arntemporary market disturbance, especially one not directly related to housing markets.rn However, this approach involves morerncounterparty risk, more vulnerability to housing market weakness when the counterpartiesrnare not diversified, and a more limited set of bidders for the risk.</p

Anotherrnpotentially powerful means of risk transfer is use of senior/subordinaternsecurity structures.  The GSEs have madernprogress in considering how such structures might work and are grappling withrnmany of the problems faced by private label securities issuers such as: duerndiligence, representations and warranties, dispute resolution, and the role ofrntrustees. If good solutions can be found for past problems, this approach mayrnbe easier than some others for non-GSE issuers to adopt. A disadvantage torntransferring losses on a small pool of mortgages in a cash transaction, ratherrnthan on a large reference pool in a synthetic transaction or insurance agreement, is that credit evaluationrncosts can be considerably higher, as investors must consider the idiosyncraticrnrisks of a particular small pool, rather than those of a cohort diversifiedrnby geography,rnlender, and sheer size. Considering ways to develop more standardization and liquidity in this marketrncould help to address some of these issues.</p

The transactions considered so far have been GSE-centricrnin that they dependrnheavily on the GSE’s existing businessrnpractices and the familiarity of loan sellersrnand investors with those practices. rnThere is a need to make these advantages more generalizable such as byrnarranging for credit enhancements or by outsourcing servicing and lossrnmitigation to firms specializing in those activities.</p

DeLeo said the GSEs have made majorrnsteps in risk transferrnthis year and, if sufficiently scalable,rnthey will provide mechanisms to freerntaxpayers from shouldering almost all thernburden of mortgage credit risk and placernthat risk in the privaternsector.  FHFA will, she said, continuernwith the GSEs to explore newrntechniques or variations tornfind the most workablernsolutions and those that show the best promise of reducing the GSEs’ footprint,rnconsistent with maintaining efficient and effectivernmortgage markets.rn

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