Investors Take On Mortgage Risk From Fannie Mae, Freddie Mac
Mortgage giants sell $48 billion of securities designed to reduce their exposure
So-called credit-risk transfers, a new type of securities, are one part of a larger government effort to revamp Fannie Mae and Freddie Mac.PHOTO: KEVIN LAMARQUE/REUTERS
Investors are snapping up securities sold by Fannie Mae and Freddie Mac that shift mortgage default risk away from taxpayers, powering a quiet transformation of the housing giants after almost a decade of government control.
Fannie and Freddie have sold roughly $48 billion of the securities since 2013, transferring a large measure of risk on roughly one-third of the single-family mortgages they guarantee. Sales are expected to reach a fresh high of $15 billion this year, up from the previous record $13 billion last year, according to J.P. Morgan Securities.
The sales mark an early step toward reducing the government’s role in the $14.4 trillion U.S. mortgage market. The amount of mortgage debt funneled through Fannie and Freddie and other taxpayer-backed entities roughly doubled after the financial crisis, to around 70%.
The progress has come despite a long-running stalemate in Congress, which has stumbled in its effort to design a replacement for the decades-old housing-finance system that centers on Fannie and Freddie.
Total issuance of credit-risk transfersecuritiesTHE WALL STREET JOURNALSource: J.P. Morgan SecuritiesNote: All data are full-year except 2017, which isthrough July 31.
.billion2013’14’15’16’170.02.55.07.510.012.5$15.0
It may not be happening as people anticipated, but “the government’s footprint in the mortgage market is receding quickly and significantly,” said Mark Zandi, chief economist at Moody’s Analytics.
The market for the so-called credit-risk transfers has boomed even as the one for privately issued mortgage-backed securities has remained mostly dormant, a sign that investors have greater comfort in the standards and transparency of these deals than in those issued by Wall Street banks that performed so poorly after the housing bust.
Fannie and Freddie don’t make loans, but buy them from lenders and bundle them into securities. Those bonds typically carry a guarantee that Fannie and Freddie will pay investors if the underlying mortgages default, leaving investors with only the risk that the bonds will lose value if interest rates rise.
The credit-risk transfers don’t carry that guarantee. Nevertheless, they have proved popular with investors, who have concluded that the yields they offer are worth the added risk. As the market has developed, banks have been willing to trade them, easing concerns that they would need to offer premium yields because they would be difficult for buyers to unload.
Reflecting the strong interest, the average yield that investors have demanded to hold one version of the instrument has fallen by more than half in just two years, to roughly 1.5 percentage points on top of a benchmark floating interest rate, according to J.P. Morgan Securities.
The pool of investors buying the securities is also widening to what many consider more stable sources of capital, a sign of their changing status. While hedge funds made up the largest group of early investors, that distinction now belongs to more traditional money managers, according to J.P. Morgan Securities. Though still small players in the market, insurance companies and real-estate investment trusts have also increased their buying in some recent deals.
Gene Tannuzzo, senior portfolio manager at Columbia Threadneedle, said he bought both Fannie and Freddie risk transfers for the firm’s Strategic Income Fund and then sold them as the market rallied.
“Liquidity has definitely improved as more securities have been issued,” he said.
The mortgage giants are transferring risk on the loans most likely to default—those of more than 20 years where homeowners have made less than a 40% down payment. Last year, such mortgages accounted for 60% of all of the single-family mortgages they acquired, according to the Federal Housing Finance Agency, which oversees the companies.
How much risk Fannie and Freddie have shed depends in part on the severity of defaults. In a normal economic expansion, investors would likely shoulder around 20% of the losses in the mortgages underlying the securities, according to a new report by Moody’s Analytics.
But that number would jump to around 60% to 70% if there were another severe recession comparable to the last one—enough, if the firms were private, to possibly avoid a federal bailout, according to the Moody’s report, which was written by analysts including Mr. Zandi.
The variability is a result of the securities’ structure. Each comprises several tranches, linked to a pool of mortgages, with losses from defaults hitting the bottom tranche first and the top tranche last.
On almost all securities, Fannie and Freddie still own the riskiest and the safest tranches, seeing it as uneconomical to sell them to investors. That means they are exposed to mild losses, largely shielded from moderate to severe losses, but vulnerable again once defaults reach a catastrophic level.
The securities are one part of a larger government effort to revamp the housing giants. Since being placed under conservatorship in 2008—when then-Treasury Secretary Henry Paulson said the government had a responsibility to address their systemic risk—the firms have adopted a more stable business model by shrinking their once huge investment portfolios and raising the fees they charge lenders to guarantee mortgages. They have also joined forces to build a common system for securitizing home loans that could ultimately be used by other firms.
The securities aren’t without controversy. Some observers have expressed concerns that Fannie and Freddie are paying investors too much for the risk they are shedding. Investors could also demand sharply higher yields in a market downturn, forcing Fannie and Freddie to either stop selling the securities, increasing their exposure to future defaults, or raise fees they charge lenders, potentially making home loans more expensive.
The securities have also been drawn into a larger debate about what the government should do with Fannie and Freddie, which stand in limbo between the public and private sectors—sending nearly all of their profits to the U.S. Treasury despite reporting quarterly earnings and having shares outstanding.
Some of the securities’ strongest advocates include those who want the companies to be dismantled, replaced with a larger number of private firms or a single, government-run utility, which they say would disperse risk and avoid another taxpayer-funded bailout.
Many shareholders, however, want to preserve the companies in near their current form while releasing them from conservatorship. One group has funded a proposal that would provide incentives for the institutions to issue risk transfers without mandating them.
Risk-transfers are a useful tool, said Landon Parsons, a senior adviser at Moelis & Company, which created the plan, but they “may not be available during a business cycle downturn at a reasonable cost.”
About Timeless Investor
My name is Samual Lau. I am a long-term value investor and a zealous disciple of Ben Graham. And I am a MBA graduated in May 2010 from Carnegie Mellon University. My concentrations are Finance, Strategy and Marketing.
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GSE’s Credit Risk Transfer Securities
It is good to know that GSE sells $48 billion of CRT securities designed to reduce their exposure. Maybe this is the way they are reforming already,
Summary,
Mortgage giants sell $48 billion of securities designed to reduce their exposure
By
Investors are snapping up securities sold by Fannie Mae and Freddie Mac that shift mortgage default risk away from taxpayers, powering a quiet transformation of the housing giants after almost a decade of government control.
Fannie and Freddie have sold roughly $48 billion of the securities since 2013, transferring a large measure of risk on roughly one-third of the single-family mortgages they guarantee. Sales are expected to reach a fresh high of $15 billion this year, up from the previous record $13 billion last year, according to J.P. Morgan Securities.
The sales mark an early step toward reducing the government’s role in the $14.4 trillion U.S. mortgage market. The amount of mortgage debt funneled through Fannie and Freddie and other taxpayer-backed entities roughly doubled after the financial crisis, to around 70%.
The progress has come despite a long-running stalemate in Congress, which has stumbled in its effort to design a replacement for the decades-old housing-finance system that centers on Fannie and Freddie.
It may not be happening as people anticipated, but “the government’s footprint in the mortgage market is receding quickly and significantly,” said Mark Zandi, chief economist at Moody’s Analytics.
The market for the so-called credit-risk transfers has boomed even as the one for privately issued mortgage-backed securities has remained mostly dormant, a sign that investors have greater comfort in the standards and transparency of these deals than in those issued by Wall Street banks that performed so poorly after the housing bust.
Fannie and Freddie don’t make loans, but buy them from lenders and bundle them into securities. Those bonds typically carry a guarantee that Fannie and Freddie will pay investors if the underlying mortgages default, leaving investors with only the risk that the bonds will lose value if interest rates rise.
The credit-risk transfers don’t carry that guarantee. Nevertheless, they have proved popular with investors, who have concluded that the yields they offer are worth the added risk. As the market has developed, banks have been willing to trade them, easing concerns that they would need to offer premium yields because they would be difficult for buyers to unload.
Reflecting the strong interest, the average yield that investors have demanded to hold one version of the instrument has fallen by more than half in just two years, to roughly 1.5 percentage points on top of a benchmark floating interest rate, according to J.P. Morgan Securities.
The pool of investors buying the securities is also widening to what many consider more stable sources of capital, a sign of their changing status. While hedge funds made up the largest group of early investors, that distinction now belongs to more traditional money managers, according to J.P. Morgan Securities. Though still small players in the market, insurance companies and real-estate investment trusts have also increased their buying in some recent deals.
Gene Tannuzzo, senior portfolio manager at Columbia Threadneedle, said he bought both Fannie and Freddie risk transfers for the firm’s Strategic Income Fund and then sold them as the market rallied.
“Liquidity has definitely improved as more securities have been issued,” he said.
The mortgage giants are transferring risk on the loans most likely to default—those of more than 20 years where homeowners have made less than a 40% down payment. Last year, such mortgages accounted for 60% of all of the single-family mortgages they acquired, according to the Federal Housing Finance Agency, which oversees the companies.
How much risk Fannie and Freddie have shed depends in part on the severity of defaults. In a normal economic expansion, investors would likely shoulder around 20% of the losses in the mortgages underlying the securities, according to a new report by Moody’s Analytics.
But that number would jump to around 60% to 70% if there were another severe recession comparable to the last one—enough, if the firms were private, to possibly avoid a federal bailout, according to the Moody’s report, which was written by analysts including Mr. Zandi.
The variability is a result of the securities’ structure. Each comprises several tranches, linked to a pool of mortgages, with losses from defaults hitting the bottom tranche first and the top tranche last.
On almost all securities, Fannie and Freddie still own the riskiest and the safest tranches, seeing it as uneconomical to sell them to investors. That means they are exposed to mild losses, largely shielded from moderate to severe losses, but vulnerable again once defaults reach a catastrophic level.
The securities are one part of a larger government effort to revamp the housing giants. Since being placed under conservatorship in 2008—when then-Treasury Secretary Henry Paulson said the government had a responsibility to address their systemic risk—the firms have adopted a more stable business model by shrinking their once huge investment portfolios and raising the fees they charge lenders to guarantee mortgages. They have also joined forces to build a common system for securitizing home loans that could ultimately be used by other firms.
The securities aren’t without controversy. Some observers have expressed concerns that Fannie and Freddie are paying investors too much for the risk they are shedding. Investors could also demand sharply higher yields in a market downturn, forcing Fannie and Freddie to either stop selling the securities, increasing their exposure to future defaults, or raise fees they charge lenders, potentially making home loans more expensive.
The securities have also been drawn into a larger debate about what the government should do with Fannie and Freddie, which stand in limbo between the public and private sectors—sending nearly all of their profits to the U.S. Treasury despite reporting quarterly earnings and having shares outstanding.
Some of the securities’ strongest advocates include those who want the companies to be dismantled, replaced with a larger number of private firms or a single, government-run utility, which they say would disperse risk and avoid another taxpayer-funded bailout.
Many shareholders, however, want to preserve the companies in near their current form while releasing them from conservatorship. One group has funded a proposal that would provide incentives for the institutions to issue risk transfers without mandating them.
Risk-transfers are a useful tool, said Landon Parsons, a senior adviser at Moelis & Company, which created the plan, but they “may not be available during a business cycle downturn at a reasonable cost.”
About Timeless Investor
My name is Samual Lau. I am a long-term value investor and a zealous disciple of Ben Graham. And I am a MBA graduated in May 2010 from Carnegie Mellon University. My concentrations are Finance, Strategy and Marketing.