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Housing Finance Reform: Fundamentals of Transferring Credit Risk in a Future Housing Finance System


Statement of Wanda DeLeo, Deputy Director, Division of Conservatorship
Federal Housing Finance Agency
Before the U.S. Senate Committee on Banking, Housing, and Urban Affairs 
December 10, 2013

Chairman Johnson, Ranking Member Crapo, and members of the Committee, my name is Wanda DeLeo and I am the Deputy Director of the Office of Strategic Initiatives at the Federal Housing Finance Agency (FHFA). Thank you for the opportunity to appear before you today to discuss the credit risk transfer activities we have asked Fannie Mae and Freddie Mac, or the Enterprises as I will refer to them, to participate in, particularly securities market sales of credit-linked debt instruments. I’d like to start by recognizing the important work this Committee has undertaken to redesign the nation’s housing finance structure, including specifically the current work of the Chairman and Ranking Member, the efforts of Senators Corker and Warner, and those of their cosponsors, as well. We remain eager to help in any way we can.

More than five years into conservatorship, the Enterprises continue to provide funding for roughly two-thirds of all new mortgages. Combined with direct government guarantees through FHA and VA, this amounts to roughly 90 percent of new loans being supported by the federal government. Enterprise losses since the financial crisis in 2008 required the Treasury to inject $187.5 billion of capital into those companies. While the new loans they insure or guarantee are of much higher quality than those that led to most of the losses, it is prudent to seek alternative funding mechanisms that place less potential burden on taxpayers. Our credit risk transfer program is designed to do exactly that.

Improved housing market conditions, coupled with policy changes and strong efforts of staff of both Enterprises to address still serious deficiencies in their business operations, have enabled a welcome return to profitability. But that should not blind us to the very real costs associated with the Enterprises’ failures. The dividends they have paid to the Treasury reflect not a return of capital, but payment for the extraordinary risk the government was forced to take in view of the potential at the time for economic disaster. The current earnings are only possible because of the Treasury investment; no one even today would be purchasing Enterprise debt in the absence of it.

It is in keeping with FHFA’s responsibilities as conservator to minimize taxpayer risks while helping to ensure the secondary mortgage market continues to serve its functions. At the same time, we are seeking to develop standards, norms, experience, and private investment capacities that can continue into the future of a new secondary market structure. Credit risk transfers can help us simultaneously in all three of our broad conservatorship goals: build, contract, and maintain. Accordingly, we have set a target for each of the Enterprises to conduct multiple types of risk sharing transactions involving single family mortgages with a total of at least $30 billion of unpaid principal balances in 2013. We specified that the transactions be economically sensible, operationally well-controlled, transparent to the marketplace, and involve a meaningful transference of risk. Further, we informed the Enterprises that our evaluation for assessing their performance on FHFA’s conservatorship scorecard objectives will also consider the utility of the transactions to furthering the long-term strategic goal of risk transfer. We will make final judgments later this year, but clearly the transactions completed this year have accomplished a great deal.

The Enterprises have initially focused on two broad categories of credit risk sharing transactions. One transaction category is pre-funded capital markets transactions, which include Freddie Mac’s Structured Agency Credit Risk securities (STACRs) and Fannie Mae’s Connecticut Avenue Securities (C-deals). In these transactions, investors buy debt securities that offer relatively higher returns if the credit performance of loans in a reference pool is good, but may lose principal when credit performance deteriorates. There is no counterparty risk for the Enterprises because when investors buy the securities, they are putting up cash that covers their maximum losses. This approach offers efficient, competitive, market pricing of risk. It also spreads risk across many investors with varying degrees of leverage, and with varying degrees of risk concentration in mortgages. Less risk concentration and less leverage has the potential to reduce systemic risk relative to past and current practices that channel the bulk of the risk into a very small number of highly leveraged institutions, such as the Enterprises. 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.

The other transaction category for this year’s Enterprise transactions is insurance or guarantee agreements. In these, a mortgage insurer, re-insurer, or other guarantor pays claims in the event of loss. These deals can take advantage of such 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.

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. FHFA worked closely with the Enterprises on each of this year’s transactions, and in each case was confident that conservatorship goals would be served. Reaching this point required strong efforts by many over an extended period of time, and I want to recognize the excellent work of the staffs of Fannie Mae and Freddie Mac, including those sitting beside me today.

2013 Securities Transactions

This year, each Enterprise 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 Enterprise by reducing the principal on the debt securities as credit performance of the reference pool deteriorates.

Freddie Mac’s transactions occurred in July and earlier this month. In the July offering, the Enterprise sold $500 million in STACR notes, resulting in credit protection on $18.5 billion of collateral consisting of mortgages funded in the third quarter of 2012. In the November offering, Freddie Mac sold an additional $630 million in STACR notes, resulting in credit protection on $23.3 billion of collateral that the Enterprise had funded in the first quarter of 2013. The STACR notes are unsecured general obligations of Freddie Mac.

The credit event that results in losses on the STACR notes is determined to occur if a loan becomes 180 days delinquent or there is a third-party sale, a short sale, a deed-in-lieu at foreclosure, or a sale of real-estate owned (REO) before 180-days delinquency. When such a credit event occurs, a credit is calculated based on a tiered loss severity schedule, where the severity increases with the cumulative unpaid principal balance (UPB) of the underlying loans that experience credit events. If calculated credit losses exceed 0.3 percent of the UPB of the reference collateral pool, the principal of the STACR notes is written down by the amount of the excess, until the calculated losses exceed three percent and the remaining value of the STACR notes is eliminated. In these initial transactions, Freddie Mac retained the risk for the first 0.3 percent of UPB and any losses beyond three percent in large part because of cost effectiveness considerations. Covering a wider range of losses may be appropriate in the future.

In each STACR transaction, Freddie Mac sold notes that provide protection on about four-fifths of the underlying loan pool to investors, retaining the risk on the balance of the reference pool. The Enterprise can elect to seek protection on some of the retained risk, but has committed to maintain a minimum five percent interest in each tranche of each deal. The risk-retention requirement is designed to align the interests of Freddie Mac and investors that have bought the STACRs.

The STACR notes have a final maturity of 10 years. With a fixed loss severity and final maturity, Freddie Mac is exposed to some basis risk on calculated credit losses on the reference pool from 0.3 percent to three percent. In addition, the Enterprise retains exposure to the first 0.3 percent of calculated credit losses and to calculated losses beyond three percent.

In October Fannie Mae issued debt securities with a similar structure. Specifically, Fannie Mae sold $675 million worth of Connecticut Avenue Securities, resulting in credit protection on $25 billion of mortgages securitized in the third quarter of 2012. A material difference compared to the STACR transactions was in the tiered loss severity schedule. Further, one tranche of the Fannie Mae security received an investment-grade rating from one credit rating agency, and that was also achieved in Freddie Mac’s second issue this month.

Legal Issues Associated with the Security Structures

Both the STACRs and C-deal were issued as senior debt of Fannie Mae or Freddie Mac. In each case, investors can rely on those Enterprises’ special credit standing, including the backing of the Treasury through the preferred stock purchase agreements, for comfort that the payments on the securities to investors will occur as specified in the terms of the notes.

Part of the purpose of these transactions, though, is to develop standardized credit risk investments that could be sold in the future by securitizers other than the Enterprises. The Enterprises ultimately hope to issue credit-linked notes through bankruptcy remote trusts that would have the same economics for investors, but a different legal structure that would not rely on an Enterprises’ credit standing, but rather on the trust holding and managing the proceeds from the note issuance. Issues that arose include questions about whether issuers or purchasers of the trust certificates would be commodity pool operators under the Commodity Exchange Act, and whether issuers could be subject to the conflict of interest rules under the Securities Act of 1933. We are working with other agencies to resolve these questions, but statutory clarifications might be helpful, and we are working with Committee staff on possible solutions. We would also note that all of these structures would be ineligible for REMIC tax treatment because they would be considered synthetic structures. If they could obtain similar treatment, the investor base for the securities would be significantly expanded.

2013 Insurance Transactions

Both Enterprises have completed insurance transactions this year, as well. In October Fannie Mae executed a pool insurance policy with National Mortgage Insurance (National MI). The policy transfers a substantial portion of the credit risk on a pool of single-family mortgages securitized by the Enterprise in the fourth quarter of 2012. The aggregate initial UPB of the loans in the pool was nearly $5.2 billion, and each mortgage had an initial LTV ratio of between 70 percent and 80 percent. Under the policy, Fannie Mae is responsible for actual credit losses on the pool up to 0.2 percent and above two percent of the initial aggregate UPB. National MI is exposed to credit losses above 0.2 percent and less than or equal to two percent of the initial aggregate UPB, but its exposure on each loan is limited to 50 percent of its initial UPB. Thus, the policy has an aggregate loss limit of about $103.4 million with a deductible of about $10.3 million. National MI will pay claims based on actual credit losses determined after an REO sale, short sale, or third-party disposition of the property. To limit its counterparty risk, Fannie Mae has required National MI to maintain a risk-to-capital ratio not to exceed 15:1 through 2015. Thereafter National MI will maintain capital levels required by Fannie Mae’s then-applicable requirements.

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. Specifically, Freddie Mac had retained the credit risk associated with approximately $4.0 billion (about 18 percent) of the UPB of the reference pool. Under the reinsurance transaction, , Freddie Mac transferred the risk on $2.9 billion of that UPB to Arch, leaving the Enterprise with retained risk on just over five percent of the total UPB, as required by the terms of the STACR transaction. Because Arch insures diversified risks, its financial health likely is less tightly tied to housing markets and mortgage performance, so it may, other things equal, be better able to pay mortgage claims in a severe housing stress environment.

Looking Forward

The Enterprises have executed transactions that transfer single-family mortgage credit risk to capital-market investors and to firms in the insurance industry. Each type of risk-transfer model has inherent strengths and weakness. From an Enterprise perspective, the sale of securities to capital-market investors provides upfront funding of credit risk without posing any counterparty risk, while transferring credit risk to an insurer leaves an Enterprise exposed to the claims-paying ability of its counterparty.

From an overall housing finance system perspective, the leverage of participating investors in capital markets transactions may not be regulated, so there may be significant variation in the amount of equity capital deployed to bear credit risk. Further, capital markets funding sources maybe more volatile as a source of funding for mortgage credit risk over the credit cycle. Transferring risk to the insurance sector could be a more stable source of funding mortgage credit risk over the cycle to the extent the financial strength and leverage can be closely monitored either by the market or through regulatory requirements.

Potential differences in the leverage of investors under the two models also have implications for their relative cost. FHFA and the Enterprises will continue to assess those strengths and weaknesses as we explore both models of credit-risk transfer in parallel. Pricing on all of the transactions this year has been attractive, suggesting that each may be scalable to a significant degree. An increased volume of issues next year will provide additional information about the depth of demand.

A potentially powerful means of risk transfer is use of senior/subordinate security structures. While none are expected this year, the Enterprises have made progress in considering how such structures might best work. In the process, they are grappling with many of the problems faced by private label securities issuers of the recent past such as: due diligence, representations and warranties, dispute resolution, and the role of trustees. This approach has an advantage in that markets have a good deal of familiarity with it, but the experience has been less than satisfactory in many cases, particularly involving private-label mortgage-backed securities. If good solutions can be found for past problems, this approach may be easier than some others for non-Enterprise 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 Enterprise-centric in that they depend heavily on the Enterprises’ existing business practices and the familiarity of loan sellers and investors with those practices. To increase the potential generality of risk-sharing approaches and reduce the dependence on the Enterprises, it may be useful to explore the potential for loan sellers to arrange for credit enhancements, such as those provided by securities or insurance before the loans are sent to an Enterprise, rather than leaving it to the Enterprise. Similarly, servicing and loss mitigation could possibly be outsourced to firms specializing in those activities. Such changes would not happen soon or quickly, but they merit consideration over time.


The Enterprises have made major steps in risk transfer this year. If sufficiently scalable, these transactions provide mechanisms to free taxpayers from shouldering almost all the burden of mortgage credit risk and place that risk in the private sector. We will, with the Enterprises, continue to explore new techniques or variations on those already tried to find the most workable solutions and those that show the best promise of reducing the Enterprises’ footprint, consistent with maintaining efficient and effective mortgage markets. Thank you and I am happy to answer any questions you may have.



​Corinne Russell (202) 649-3032 / Stefanie Johnson (202) 649-3030
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