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AB 2019-06: Credit Risk Transfer – Analysis and Reporting
This advisory bulletin articulates the Federal Housing Finance Agency’s (FHFA) supervisory expectations for the analysis and internal reporting of certain proposed or in-force credit risk transfer (CRT) activities. This advisory bulletin applies to Fannie Mae and Freddie Mac (Enterprises) and is effective immediately.
The scope of this advisory bulletin addresses risk analysis and reporting for individual and aggregate CRT activities. This advisory bulletin excludes primary mortgage insurance, seller indemnification, collateralized lender recourse, and multifamily lender loss sharing.
Enterprise CRT activities include debt instruments with varying structures and characteristics as well as insurance or reinsurance transactions and senior/subordinate securitizations. CRT programs are integrated with core single-family and multifamily business activities and affect the Enterprises’ overall credit risk profiles.
The comprehensive analysis and internal reporting of CRT activities support Enterprise safety and soundness. The Enterprises’ CRT programs could pose considerable financial risk exposure if associated risks are not adequately understood and managed. Robust risk analysis coupled with effective reporting to senior management and, as appropriate, the board of directors could identify potential risk and further support the oversight of the CRT program.
The guidance section outlines FHFA’s supervisory expectations regarding analysis and reporting for CRTs. The Enterprises may augment the analyses included in this advisory bulletin with other types of analyses deemed appropriate by management or the board of directors.
The ownership or guarantee of mortgage-related instruments exposes the Enterprises to credit risk. Credit risk transfers can moderate the risk of credit-related losses and expenses by mitigating the Enterprises’ credit risk exposure. The Enterprises routinely transfer credit risk to third-party investors through the capital markets, and to insurance and reinsurance companies through negotiated transactions.
The use of CRT transactions alters the earnings and credit risk profiles of the Enterprises by transferring some portion of estimated credit losses. Modeling applications estimate these credit losses. Credit losses transferred to investors or insurers, over the term of the CRT transaction, could differ significantly from the Enterprises’ original estimates of expected credit losses absorbed by investors or insurers.
This advisory bulletin discusses approaches designed to provide both an economic view as well as a view into the financial impact of CRT transactions.
Risks associated with CRT transactions, as noted in more details below, include residual credit risk, financial risk, price risk, model risk, counterparty credit risk, and mark-to-market risk. Fully understanding the risks and their potential earnings and capital impact is an important step in determining appropriate risk mitigants for those risks that can be controlled and reasonably managed.
Residual Credit Risk
Residual credit risk refers to the credit risk remaining with the Enterprises from the loans in the reference pool. Typically, only a portion of credit risk is transferred at the origination of the CRT transaction. Additionally, termination dates for some CRT transactions may be earlier than the contractual maturity of the underlying single-family or multifamily mortgage loans in the reference pool. If credit loss events on single-family or multifamily loans in the reference pool occur after the maturity of the CRT issuance or insurance transaction, the Enterprises remain exposed to residual credit risk for the lifetime of loans remaining in the original reference pool.
Financial risk is the uncertain net earnings and balance sheet impact attributed to the costs and the credit loss protection provided by investors or insurers. The Enterprises’ cost to purchase credit protection through CRT transactions may be substantial in relation to guarantee fee revenue. The expected credit risk mitigation provided by investors and insurers is not precisely known at origination and requires complex calculations to estimate. Financial risk could be significant and could negatively affect corporate profitability and capital levels.
Price risk refers to the risk that it may not be feasible for an Enterprise to enter into new CRT transactions because of market-driven costs. An Enterprise’s ability to transfer credit risk on an ongoing and regular basis is dependent on third-party investor or counterparty demand to enter into new transactions, but this demand may significantly weaken or disappear during periods of adverse economic or poor market conditions. The interest of market participants may vary over housing price cycles and could influence demand for new and existing CRT instruments. The countercyclical nature of some CRT transactions could expose the Enterprises to price risk, as they may incur considerably higher costs by entering into CRT transactions during times of significant economic downturns or severely adverse market disruptions.
Model risk refers to the earnings and capital exposure from inadequate model results or weaknesses in model governance, processes, or controls. Enterprise management relies in part on sophisticated quantitative analyses and complex models. These models estimate Enterprise credit risk, including the financial costs of CRT transactions. Estimates of mortgage interest rates and house price movements are significant factors in management’s analysis. Models and analytical processes are sensitive to data inputs, key assumptions, and the complexity of calculation methodologies.
Counterparty Credit Risk
Some CRT transactions introduce counterparty credit risk. While CRT transactions serve to reduce credit risk exposure from individual borrowers, the reduction may be partially offset by added credit risk from corporate counterparties. Counterparty credit risk is introduced in insurance-related CRT transactions, as the risk that an insurance company will not fulfill its potential obligation is substituted for the risk that individual borrowers will not meet their obligation with respect to the underlying mortgage loan.
Mark-to-market risk refers to the market price volatility or sensitivity associated with CRT issuances. The Enterprises are exposed to mark-to-market risk for some CRT transactions. Changes in fair market values may have a negative financial performance or capital impact. For example, an Enterprise may issue unsecured debt in the form of a CRT transaction and record fair market gains or losses based on price changes. Hedging activities may mitigate the underlying mark-to-market risk inherent in the CRT transaction.
This section outlines FHFA’s supervisory expectations regarding analysis and internal reporting for CRTs. The analyses described below will allow senior management to understand individual and aggregate CRT transactions and inform corporate business decisions, and the aggregate reporting will inform the board of directors or a designated committee of the board. These analyses should be completed in a timely manner, and documentation should include an explanation and support for significant management assumptions or estimates, detailed model results, and key analytical factors.
I. Analysis of CRT
Analyses A, B, and D described below do not depend on economic, regulatory, or imputed capital or capital costs.
A. Analysis of Expected Revenues and Expected Costs
1. Transaction-Level Analysis
Transaction-level analyses should thoroughly evaluate the financial value of individual CRT transactions, that is, the expected revenues and expected costs that result from CRT transactions. Revenues and costs include guarantee-fee income, expected default costs, and transaction costs associated with a CRT structure. The cashflow analysis should cover the full term of the underlying mortgages in the reference pool. Management should use stochastic credit risk models to generate forecasts of prepayment, default, and severity using relevant macroeconomic factors. The macroeconomic factors, at a minimum, include interest rates and house prices. For a meaningful analysis, a wide-range of economic scenarios should be included.
Two types of transaction-level analyses should be performed on the reference pool: (a) transaction analysis without CRT; and (b) transaction analysis with CRT. Both types of transaction-level analysis should use the methods described above.
(a) Transaction Analysis without CRT. This analysis evaluates the estimated cashflows by calculating estimated expected pre-tax revenues (guarantee fees) and associated expected expenses (including credit losses and interest expense) for the reference pool. Management should calculate the revenues and expenses for each of the simulated paths. The path-level results should then be aggregated to determine overall expected net revenue.
(b) Transaction Analysis with CRT. This analysis evaluates the estimated cashflows by calculating estimated expected pre-tax revenues (guarantee fees) and associated expected expenses (including credit losses and interest expense) for the reference pool. Management should calculate the revenues and expenses for each of the simulated paths with the proposed CRT transaction. The path-level results should then be aggregated to determine overall expected net revenue.
In addition to analyses (a) and (b), management should develop at least one stress test by evaluating revenue and credit losses absorbed by investors or insurers for paths that exceed a specific high confidence level (e.g., 90%, 95%, or 99%). For CRT transactions with a counterparty credit risk component, transaction analyses should incorporate an assessment of the credit risk associated with the underlying counterparty.
2. Consolidated Analysis
Consolidated analysis should assess the net financial impact of aggregated CRT transactions on financial performance. This analysis should calculate the impact of existing CRT transactions incorporating all business segments of corporate revenue and expenses. The results should provide insight into the aggregate and full impact of CRTs.
In order to conduct the consolidated analysis, the stochastic analysis to estimate net revenues and credit losses absorbed by investors or insurers described above should be estimated (ex-post, on a transaction level) and aggregated.
B. Earnings Forecast Analysis
Earnings forecast analysis should assess the annual forecasted generally accepted accounting principles (GAAP) impact for aggregate CRT activities. This analysis should be designed to calculate the impact of existing CRT transactions on future corporate revenue and expenses. The analysis should cover each year of the duration of all CRT transactions existing at the time of the analysis.
The methodology used for this earnings forecast analysis should be comparable to the transaction-level financial analysis (described above) to allow for meaningful benchmarking analysis. Specifically, individual transactions should be modeled stochastically before results are consolidated. Key model methodology, assumptions, and inputs should be transparent and well supported. Stress testing should also be a component of the earnings forecast analysis to add a meaningful dimension. The earnings forecast analysis should include sufficient time period intervals to allow Enterprise management to assess significant timing differences between CRT expenses or costs and the absorption of credit losses by investors or insurers that may occur well after the initial CRT transaction.
C. Price Risk Analysis
The price risk analysis should measure the strength and health of the CRT market in order to assess the economic sensibility of entering into new CRT transactions. The cost to transfer credit risk may vary depending on the position of the economy in the economic cycle. It may be more expensive for the Enterprises to transfer credit risk during periods of economic instability or uncertainty. Enterprise management should develop measures to analyze CRT price risk.
Enterprise secondary market purchases or sales of previously issued CRT securities should include consideration of the potential impact on corporate CRT strategies and overall CRT effectiveness. These transactions could reduce the amount of credit risk that has previously been transferred through a CRT transaction. For this reason, an analysis of the potential impact to CRT effectiveness should be performed prior to secondary market transactions.
D. Industry Analyses
Credit rating agencies and other industry participants play a role in the Enterprise CRT market. Industry participants may conduct analytical assessments for individual CRT instruments using proprietary models and evaluation techniques. Management should review and understand the analytical approach and results of analyses performed by rating agencies or other industry participants and identify significant differences from internal Enterprise analyses.
II. Management and Board of Directors Reporting
The management and board of directors reporting described in this section may be presented as independent, standalone reports, or incorporated into existing reporting processes. If incorporated into existing reporting processes, management should ensure that CRT analysis results are given attention commensurate with the significance of the analytical results and findings. Whether standalone or incorporated into an existing reporting process, the CRT reports should contain sufficient detail to adequately inform the intended audience and sufficiently support related business decisions.
A. Analysis of Expected Revenues and Expected Costs
The results of the transaction-level analyses for individual single-family CRT transactions should be included in transaction-level, pre-transaction analysis reported to business line management. For multifamily CRT transactions, results may be aggregated and reported to business line management on a quarterly basis. Senior management should also review a summary of transaction reports.
2. Consolidated Analysis
The CRT consolidated analysis should be prepared on at least an annual basis with detailed results reported to senior management. The board of directors or designated board committee should review a summary of the consolidated analysis.
B. Earnings Forecast Analysis
The CRT earnings forecast analysis should be prepared on at least an annual basis with detailed results reported to senior management. The board of directors or designated board committee should review a summary of the earnings forecast analysis.
Price risk analysis results should be incorporated into senior management reporting.
Internal evaluations of industry CRT analyses should be reported to business line management at least annually, with more frequent reporting or reporting to Enterprise management and, the board of directors, or designated board committee, as appropriate, if interim analyses indicate significant findings.
Related Guidance and Regulations
12 CFR Part 1236, Appendix, Prudential Management and Operations Standards.
12 CFR Part 1239, Responsibilities of Boards of Directors, Corporate Practices, and Corporate Governance.
Interest Rate Risk Management, Federal Housing Finance Agency, Advisory Bulletin AB-2018-09, September 28, 2018.
Model Risk Management Guidance, Federal Housing Finance Agency, Advisory Bulletin AB-2013-07, November 20, 2013.
FHFA has statutory responsibility to ensure the safe and sound operations of the regulated entities and the Office of Finance. Advisory bulletins describe FHFA supervisory expectations for safe and sound operations in particular areas and are used in FHFA examinations of the regulated entities and the Office of Finance. Questions about this advisory bulletin should be directed to:
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