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01 05 2016 | by Victor Xing | Capital Markets

Fannie and Freddie’s Credit Risk Transfer Derivatives

Birth of credit risk transfer derivatives – lessons from 2008

A painful lesson from the 2008 financial crisis was the unsustainable framework of having Fannie and Freddie guarantee credit risk of agency mortgage backed securities held by private investors.  When home loans default, Fannie and Freddie, i.e. tax-payers, are obligated to step in to shield capital market investors from credit events (even if mortgage borrowers default and unable to pay back their loans, Fannie and Freddie would ensure investors get their principal back).  Losses from these operations reached $14.9 billion across multiple Government-sponsored enterprise (GSEs) and triggered Federal takeover of Fannie Mae and Freddie Mac.
Fannie and Freddie couldn’t (and shouldn’t, as some have argued) shoulder the default risk for majority of securitized U.S. home loans during acute credit crises.  Below are Fannie and Freddie’s stock valuations from 1989 to 2016.
Credit risk transfer instruments would serve to dampen credit events' impact on GSEs
Credit risk transfer derivatives may serve to dampen credit events’ impact on GSEs. Data source: Bloomberg L.P
Thanks to these measures, holders of agency MBS such as mutual funds, central banks, hedge funds, pension funds, insurance companies, etc, are only exposed to interest rate risk and reinvestment risk.
Following the crisis, Federal Housing Finance Agency outlined plans to transfer GSE credit risk to private investors, thus giving birth to the credit risk transfer (CRT) instruments.
Before analyzing the derivatives mentioned in the news article (which were first sold to the public in 2013), it is helpful to highlight the G-fees collected by the GSEs – they play a significant role in CRT instruments’ cashflow:
  • A home buyer’s mortgage rate includes GSE guarantee fees (G-fees) and loan level price adjustment (as a percent rate).  This is the reason why agency MBS coupon rates are higher than the actual mortgage rates
  • G-fees are collected to cover “GSE operational costs associated with guarantee of timely principal and interest payments, capital buffers and administrative costs”
  • An increasing portion of Fannie Mae’s net income in recent years has been derived from guaranty fees rather than from interest income earned on the company’s retained mortgage portfolio assets (source: Fannie Mae 2Q 2015 quarterly annual results)
New credit risk transfer instruments have the potential to lower G-fees
Steady rise of Fannie Mae and Freddie Mac G-fees.  Source: FHFA

Credit Risk Transfer (CRT) instruments – a 30,000 feet overview on how credit-linked notes work

Cash flows of Fannie Mae and Freddie Mac’s synthetic credit risk transfer debt obligations are entirely separate from those of agency MBS (meaning home owners’ mortgage payments will never be used to pay holders of CRT debt), but CRT cash flows are designed to respond to credit events experienced by “reference pools” that mirror credit conditions of actual agency MBS pools

  • Investors would buy individual “slices” of CRT debt issuance representing various tranches of credit risk
  • Fannie Mae and Freddie Mac would use g-fee and other sources of income to fulfill their CRT debt obligations
  • Reference pools of home loans are used to determine CRT instruments’ coupon and principal payments
  • As loans within the reference pools experience credit events, Fannie and Freddie would decrease their CRT instruments’ coupon and principal payments based on their severity
  • Thus, cash flow of CRT instruments are “linked” to the credit risk of reference pools, which mirror agency MBS pools, effectively “transmitting” credit risk to private investors

Breaking down Fannie’s CAS and Freddie’s STACR

Fannie Mae: Connecticut Avenue Securities (CAS)

Fannie Mae CAS (credit risk transfer derivative)
Fannie Mae CAS (credit risk transfer derivative)
  • About Fannie Mae Credit-Linked Debt Issuance:
    • CAS are unguaranteed and unsecured securities issued by Fannie Mae.
    • Coupon payments on the securities are paid to investors by Fannie Mae on a monthly basis.
    • Payment on the securities is based on the performance of a “reference pool” of loans that were recently securitized into Fannie Mae MBS.
    • As loans in the reference pool are paid, the principal balance of the securities is paid, so that CAS deals mirror the payment and prepayment behavior of the mortgage loans in the reference pool.
    • If the loans in the reference pool experience credit defaults, the investors in the CAS deals may bear losses.
    • Under no circumstances will the actual cash flow from the loans in the reference pool be paid or otherwise made available to the holders of the securities.
    • Fannie Mae may retain a first loss piece and will retain a vertical slice of each CAS transaction to ensure aligned interest with investors, in addition to retaining an unfunded senior portion of the transaction.
  • About the reference pool:
    • The reference pools for each CAS deal are large and diversified, consisting of 30-year fixed-rate, fully amortizing, full documentation single-family, conventional fixed-rate mortgage loans that were acquired by Fannie Mae during certain specified periods.
    • Reference pools for each transaction are currently divided into two loan groups based on original loan-to-value (LTV). Each reference pool will generally include loans with original LTV ratios between 60.01% and 80.00% or loans with original LTV ratios between 80.01% and 97.00%.
    • Reference pools will exclude loans originated under Fannie Mae’s Refi Plus program (which includes loans originated under the Home Affordable Refinance Program), as well as loans that have ever missed more than one 30-day payment since acquisition.
    • Fannie Mae’s quality control process is applied to all loans that are included in each reference pool in the same manner as applied to all loans in Fannie Mae’s guaranteed portfolio. There is no difference in loan servicing practices between loans that are in a reference pool and loans that are not included in a reference pool.
  • Key differences between CAS and Standard Fannie Mae Debt:
    • Investors in CAS deals may experience a full or partial loss of their initial principal investment, depending upon the credit performance of the mortgage loans in the related reference pool.
    • The rate and timing of principal and the yield to maturity on the CAS deals will be related directly to the rate and timing of collections of principal payments on the loans in the related reference pools.
    • Fannie Mae’s obligations under our CAS deals are governed by the applicable Debt Agreement and defined in the related Prospectus. CAS deal securities are not governed by Fannie Mae’s Universal Debt Facility Offering Circular.

Freddie Mac: Structured Agency Credit Risk (STACR)

Freddie Mac STACR (credit risk transfer derivative)
Freddie Mac STACR (credit risk transfer derivative)
  • STACR Characteristics
    • 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 for fixed severity and 12.5-year final for actual loss
    • 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
  • STACR Reference Pool
    • A large and highly-diversified reference pool that helps to provide more stable and predictable performance
    • Freddie Mac’s Underwriting Standards
    • Freddie Mac’s internal fraud prevention and quality control review process
    • Standardized servicing guidelines that are uniform across Freddie Mac’s entire portfolio
    • Freddie Mac’s internal quality control sampling strategy will not distinguish between STACR Reference Pool loans and non-STACR Reference Pool loans
  • Key Differences Between STACR Debt and Standard Freddie Mac Debt Securities
    • STACR debt investors may not receive their full principal and will receive periodic payments of principal as well as interest
    • Periodic and ultimate principal payments on STACR debt are influenced by the delinquency and principal payment experience on a STACR Reference Pool, in addition to predetermined principal payment rules
    • STACR debt coupon yields will likely be established at higher levels than standard Freddie Mac debt offerings


Instruments such as STACR and CAS represent initial steps by the FHFA to first reduce and then eliminate Fannie and Freddie’s roles in the mortgage process in the long term.  The current framework remains vulnerable to another credit crisis, and investors’ reactions to these debt issuance are somewhat mixed (please see: Fidelity Shuns Risk-Sharing Bonds as Watt Lifts Goals).  Nevertheless, some market participants expect CRTs’ market liquidity to improve in the future as issuance increase, assuming FHFA maintains its current policy and continues to tweak its risk transfer program.
Credit Risk Transfer Transactions
Another long-term priority for FHFA is our work with the Enterprises to transfer credit risk to the private sector through various financial transactions. This initiative ensures that the private sector continues to assume meaningful credit risk, with the Enterprises remaining as backstops to cover catastrophic risk. Since 2013, the Enterprises have transferred a significant portion of credit risk on single-family mortgages with a total unpaid principal balance exceeding $700 billion. Both Fannie Mae and Freddie Mac are on track to exceed our2015 Conservatorship Scorecard credit risk transfer objectives by comfortable margins.
As the Enterprises have gotten these risk transfer transactions up and running, we have been strategic about which loans to target. Instead of using a random sample of Enterprise loans, we have targeted new loan purchases with the greatest credit risk. The targeted loans include new acquisitions of 30-year fixed-rate mortgages that have loan-to-value (LTV) ratios exceeding 60 percent, excluding HARP refinances. The Enterprises are currently transferring significant credit risk on approximately 90 percent of these targeted loans, the bread and butter of their single-family purchases. This approach has made the transactions easier to scale up and more economical, with the Enterprises and taxpayers getting a greater bang for their buck.
As part of our next steps, we want to refine and further standardize the Enterprises’ debt, reinsurance and upfront offerings. This will help broaden liquidity. We will continue to work with the Enterprises on other innovative transaction types, such as credit-linked notes. We will also aggressively continue our work to analyze, assess, and define upfront credit risk transfers. We are committed to engaging stakeholders as part of this process.
While a great deal has been accomplished in a short time, it is still early in the development of the risk transfer market. FHFA and both Enterprises are committed to building on our recent progress, and we view credit risk transfers as a key part of Fannie Mae and Freddie Mac’s credit guarantee business going forward.

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