Freddie Mac's K-Deals; a Model for Secondary Market Reform?

A senior Freddie Mac executivernsuggested today that policymakers consider his company’s model for securitizingrnmultifamily loans as they grapple with shielding the government from creditrnrisk while reforming the secondary market. rnSenior Vice President David Brickman, writing in Freddie Mac’s ExecutivernPerspectives Blog, said “K-Deals,” is used for almost all apartment loan purchases,rnthe vast majority of which support affordable rental housing.  That model could satisfy policymakers’ searchrnfor a system where private capital bears the risk of most residentialrnmortgages, with the government serving as a backstop only in the case of a majorrneconomic catastrophe. </p

When Freddie Mac purchases loansrnthey are put into diversified pools, and placed into securities comprised of<btwo classes of bonds: guaranteed senior or subordinate bonds and unguaranteed orrnmezzanine bonds.   Private purchasers of subordinate bonds or “B-piece’rntypically represent the first 7.5 percent of a mortgage pool and are in the “first-lossrnposition” in the event of default   Ifrnlosses exceed that 7.5 percent level, something Brickman calls “unlikely,” lossesrnwould then be absorbed by holders of the mezzanine bonds, which representrnanother five to 10 percent of a K-Deal mortgage pool.</p

The aggregate 15 percent or so ofrnthe pool should be sufficient to absorb all the losses if even half of all thernloans were to default.  (Brickman pointsrnout that Freddie Mac’s historical average multifamily loss severity over thernlast 20 years has been 28.7 percent.)   These two classes of unguaranteed bonds actrnlike a succession of firewalls: only after losses in the total pool (and notrnloan by loan) exceed the total amount of subordination in each of thernunguaranteed classes would Freddie Mac be exposed to a single dollar of creditrnloss. “Given that our current loan delinquency rate is just 0.06 percent andrnour loss rate is a microscopic 0.01 percent, 15 percent is a very big level ofrnprotection,” Brickman says, “Thus, the senior bonds we guarantee, where thernrisk is borne by U.S. taxpayers, have so little risk exposure that they, inrneffect, function more like catastrophic insurance for investors.”</p

This financing structure, unique tornFreddie Mac, has financed $60 billion in apartment loans. Even during thernheight of the financial crisis the multifamily portfolio delinquency rate wentrnno higher than 0.26 percent compared to over 11 percent for privately fundedrnsecurities (CMBS.)  So far this yearrnthere have been net credit losses of $3 million on a $130 billion portfolio.</p

He credits the quality of loanrnunderwriting for the K-Deal success. A new K-Deal is issued about every threernweeks and the 80 underlying loans are underwritten, structured, and priced byrnFreddie Mac staff with oversight from a subordinate bond investor, multiplernmezzanine investors, and a dozen or more investors in senior bonds. Investors, includingrnconventional real estate investors, life insurance companies, pension fundrnmanagers and major financial institutions, rating agencies, master and specialrnloan servicers, Wall Street analysts, and others also probe Freddie Mac’s creditrnstandards, asset quality, and program changes. This collective oversight,rnBrickman says, instills market discipline and forces the company to continuouslyrnimprove its securities program in order to continue to finance affordablernrental housing.</p

Prior to 2008 Freddie Mac financed<b98 percent of multifamily loan purchases through its retained portfolio, thernrisk for which was assumed by taxpayers when the company was placed inrnconservatorship.  K-Deals and other formsrnof securitization supported the remaining two percent. It took just four yearsrnto completely reverse these figures, “a testament to our ability to innovate,rnlearn from the capital markets, and implement a completely new business model,”rnhe said.</p

To accomplish this the companyrnlooked for ways to marry a CMBS-like structure where it could lay offrnsignificant amounts of risk with features commonly found in portfolio lendingrnthat provided some flexibility to borrowers. Issuing the first modern Krncertificate also required significant transformation of infrastructure  </p

The first certificate was issued inrnJune 2009 and 50 more have followed, financing more than two million apartmentrnunits and contributing about $5 billion in net segment earnings to Freddie Mac.  Brickman said the company has worked to avoidrntaking advantage of its position as a government-sponsored enterprise, insteadrntrying to establish best practices in mortgage securitization, creditrnstandards, and asset management. </p

Freddie Mac has transformed thernmultifamily business from one of a “buy and hold” investor that ultimatelyrnplaced U.S. taxpayers in a first-loss position to one of a true financialrnintermediary, making markets and providing liquidity in all economic cycles,rnBrickman said.  “By its programrnstructure, K-Deals offer one proof point that mortgage securitization, if donernright, can attract substantial private investment while assuring market supportrnfor affordable rental housing.”

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