Tuesday, August 6, 2013

Freddie Mac takes the first step in transferring mortgage default risk to the private sector

NY Times: - In an appearance in Phoenix, Mr. Obama will endorse bipartisan efforts in the Senate to wind down the two companies and end their longtime implicit guarantee of a federal government bailout. That dread prospect, once thought improbable, was realized in the fall 2008 financial crisis; Fannie Mae and Freddie Mac, then bankrupt, were made conservators of the government at great cost to taxpayers, who only now are being repaid.

The president, according to administration officials, will make clear that he will only sign into law a measure that puts private investors primarily at risk for the two companies, which buy and guarantee many mortgages from banks to provide a continuing stream of money for lenders to provide to additional home buyers.
"Wind down the two companies and end their longtime implicit guarantee" is a hell of an undertaking, considering that transferring these agencies into private hands did not work so well the last time. What about simply getting rid of them?  The problem is that the US banking system simply can not absorb the mortgage loan volumes currently generated in the US. And with the new Dodd Frank-based capital constraints on banks, adding massive mortgage portfolios to their balance sheets will be even more difficult. The only way to reduce this reliance on the federal government is to involve private investors in underwriting mortgage credit risk.

Currently the bulk of the default risk on mortgages is borne by the taxpayer (via Fannie, Freddie, FHA, etc.). Investors only assume the mortgage prepayment risk - via agency MBS securities (although they effectively pay the government some fees to take mortgage default risk). Do investors have any appetite for a security that allows them to take on credit risk as well - and get compensated in the process?

Prior to the financial crisis, the non-agency MBS business was fairly active. However given the artificially low mortgage rates (driven by implicit government guarantees for the GSEs and their low funding cost), the only way investors could make money was in the non-traditional mortgage space (sub-prime, Alt-A, etc.) - with the help from the rating agencies of course. We all know how that turned out. As a result, the non-agency residential securitization business has virtually disappeared, leaving the responsibility for such securitization (and risk) to the taxpayer - see charts below for illustration.

Source: SIFMA

Now, under pressure from the federal government, Freddie Mac is trying out an experiment. The goal is to create a security to allow investors to take on mortgage default risk. The current structure (shown below) is offering subordinated first-loss tranches with no principal guarantees. Defaults are defined as 180+ day delinquency or short-sale, REO sale, etc. Once there is an event of default, the investor's principal is reduced by a predefined amount (severity). Effectively Freddie is buying a CDS protection on a tranche of its portfolio from investors at a predetermined recovery level. The investor knows exactly what the losses will be based purely on the number of defaults - which is easier to project and model. Only class M1 and M2 (below) will be sold to investors - although Freddie would probably love to sell the B-H (equity tranche) as well.

Freddie Mac: -
  • One of the industry’s largest and most diversified reference pools
  • Freddie Mac holds the senior risk, which is unfunded and not issued
  • Senior mezzanine and junior mezzanine notes, which are not guaranteed by Freddie Mac, are sold to investors 
  • Freddie Mac may retain a first-loss piece
  • STACR notes have a 10-year final maturity
  • The notes are paid monthly principal similar to a senior/subordinate, private label residential mortgage backed securities structure
  • Losses based on credit events in the reference pool are allocated to the Notes in reverse order of seniority, and reduce the balance of such Notes

Source: Freddie Mac

If this works, it will be an important first step in getting private investors engaged in this business. It will also create price discovery to allow the agencies to properly price the so-called guarantee fee (the insurance premium the agencies charge for MBS principal protection).
Barclays Research: - This structure protects the taxpayer from certain risks by transferring them to the private market, provides the GSEs a way to achieve true risk-based pricing of the guarantee fee and is likely to be appealing to a range of political camps. Importantly, it achieves all of these without affecting the agency MBS market.
Pulling the government "guarantee" plug from the GSEs at this stage will destroy the housing market - potentially plunging the nation into another recession. To do it gradually however will take years in order for the private sector to absorb some of this risk - potentially using structures like these for a portion of it. It's not clear how large such a program can get, particularly if house price appreciation slows. It is however a certainty that the more of the mortgage risk is shifted to the private sector, the higher the mortgage rates will get.

Furthermore, if the guarantee fees become linked to the pricing of such securities, the mortgage market will become highly procyclical. When investors become concerned about the housing market, mortgage rates will rise (due to higher cost of the guarantee), putting more downward pressure on the housing market and so on, potentially temporarily freezing the mortgage market altogether.

These are enormous challenges to overcome and there is quite a bit of skepticism about the new proposal from the Obama administration. Nevertheless, this Freddie Mac structure (which got very little press so far) is the first step.



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