Changing the rules

IFR Top 250 Borrowers 2015
6 min read

The US Federal Housing Finance Agency wants Fannie Mae and Freddie Mac to use capital markets to reduce their dependence on the taxpayer. Freddie’s credit risk transfer programme might just do the trick.

When Donald Layton joined Freddie Mac as chief executive in 2012, the team working on credit risk transfer was what he now describes affectionately as the “skunkworks” – a small group of people developing a new idea that no one took very seriously at the time because it was such a departure from the company’s existing business model.

But three years later, Freddie Mac’s Structured Agency Credit Risk (STACR) debt notes are fast becoming an accepted and popular financial instrument in their own right, allowing the company to tackle the massive build-up of credit risk that proved to be its undoing during the financial crisis.

“STACR has been a strategic game-changer for Freddie Mac and the whole of the US financial system. Having an economically viable mechanism to transfer credit risk to the private capital markets at a reasonable price is proving to be a win-win for everyone,” said Layton.

Established by US Congress in 1970, Freddie Mac provides vital support to the US housing market by buying up mortgages from lenders, thereby increasing their capacity to lend. But while it had historically been able to transfer its substantial liquidity risk and interest rate risk to investors by issuing mortgage-backed securities, it was left with the credit risk.

Since being placed into conservatorship in September 2008, both Freddie Mac and Fannie Mae have been under pressure from policymakers at the Federal Housing Finance Agency (FHFA) and the US Department of the Treasury to reduce taxpayer liability for both government-sponsored enterprises (GSEs).

“Freddie and Fannie were always restricted by their government charters to being mortgage monolines, which was positive in that they could channel very focused support to the housing market, but it also created possibly the largest source of concentration risk in the US financial system, with trillions of dollars of credit risk sitting on the books,” said Layton.

For the family

The concept of transferring credit risk first came to fruition in 2009 with the launch of the K-Deal transactions for Freddie Mac’s multi-family business. Multi-family mortgage purchases, which are typically backed by apartments rather than houses, carry less risk than single-family mortgages, but the K-Deal programme has nonetheless been a success story for Freddie over the past six years.

Roughly 90% of multi-family mortgage purchases are now securitised through K-Deal transactions, with more than US$100bn issued through 80 deals since 2009. Conceptually, the K-Deal programme created a template for the development of a credit risk transfer product for the larger single-family business, but in reality the two markets are structured very differently.

“K-Deals work very well for apartment house lending, but policymakers were much more focused on the single-family business because it’s a larger market and was the source of the problems during the crisis. Given the greater complexity of the single-family business, it required a research and development effort in its own right, which led to the launch of STACR in 2013,” said Layton.

The STACR notes are effectively bonds issued by Freddie Mac, with the principal determined by the performance of a diversified reference pool of mortgages. The firm has used its own cost of capital models to structure the notes in a way that balances the need to efficiently transfer a significant portion of credit risk with the necessity of creating an economically attractive product for real-money investors.

Since its first issue in July 2013, Freddie Mac has completed 13 STACR transactions, with a total value of nearly US$10bn. Among its four issues so far in 2015 was a record US$1.01bn transaction in April, which had been upsized from US$720m due to market demand. The deal was significant in that it was the first time investors bore the risk of losses based on actual severity, as it did not include a pre-determined severity formula as in previous issues.

“Investors are getting more comfortable with the product, so they will take more risk in some cases. Moving STACR from fixed severity to loss based on actual severity means we can transfer more credit risk to investors and reduce accounting volatility on our balance sheet, which is positive for both the company and the taxpayer,” said Layton.

Seven years on

Nearly seven years on from its being placed into conservatorship at the height of the crisis, Freddie Mac has clearly positioned itself on a more stable footing, but both Fannie and Freddie remain under pressure from the FHFA as their conservator.

Among three strategic goals set for the GSEs last year, the FHFA demanded that they reduce taxpayer liability by increasing the role of private capital in the mortgage market. Deepening credit risk transfers for both the single-family and multi-family business is central to achieving that objective.

“Given the two-year development phase before the first STACR issue, we’re probably now in year four of what will be a decade-long evolution of an asset class that also includes our ACIS reinsurance transactions and other new structures we plan to introduce in the near future. These offerings represent a material de-concentration of risk in the financial system, so it’s imperative that we get them right, and we are continuing to tweak our products to make them more effective,” said Layton.

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Changing the rules
Freddie Mac