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GSEs' risk-sharing could lead to mortgage-rate volatility, Urban Institute says

Freddie Mac buildingRisk sharing is the new norm for Fannie Mae and Freddie Mac, which have been offloading much of the default risk of the loans backing their securities through deals with private investors.

But according to the Urban Institute, the government-sponsored enterprises (GSEs) could be creating another form of risk with the current approach. Mortgage rates could become much more volatile one day, the policy think tank contends, because the GSEs' risk-sharing program relies too much on the whims of hedge-fund managers and investment banks, and the fluctuations of the bond markets.

Fannie and Freddie first began offloading the default risk in 2013, and have now been directed by their regulator, the Federal Housing Finance Agency, to transfer risk on 90 percent of the loans that are purchased and securitized. The GSEs have predominantly shared risk by selling bonds to institutional investors, like hedge funds, insurance companies and banks, through Fannie’s Connecticut Avenue Securities (CAS) and Freddie’s Structured Agency Credit Risk (STACR) programs. These risk transfers have often been called in the industry “back-end deals” because the risk is transferred to a private company after Fannie and Freddie have purchased the loans.

Karan Kaul, a research analyst with the Urban Institute, said recent volatility in the spreads of these bonds is a good argument for the GSEs and their regulator to explore sharing risk through deeper front-end insurance coverage by private insurers, reinsurance companies and through lender-recourse loans, which give lenders more power to recoup losses when loans default.

The riskiest classes of the CAS and STACR bonds have experienced considerable volatility in spreads demanded by investors. That is true particularly of the spreads for of Tranche B  bonds — which shot up earlier this year as bond investors were jittery over the drop in oil prices and the slowdown in China, and other reasons. Spreads have since come back down.   

 “Capital markets are, by nature, more volatile than, say, a guarantor approach or an insurance approach,” Kaul told Scotsman Guide News. “If you look at the private mortgage insurers, they don’t change their pricing every day. They change their pricing maybe once a year. If there is a shift in the industry or a marked increase in their costs, they may adjust their pricing.

"What you see in capital markets is these securities get traded day in and day out," Kaul adds. "You see prices of these securities change in response to the unemployment number, for example, consumer sentiment or [if] house price increase or decline. You don’t see that kind of changes in prices of credit risk through other avenues.”   

Fannie Mae’s CAS and Freddie’s STACR offer securities in four tranches, which are backed by pools of home mortgages. Each bond pool has a different risk rating. The investors agree to assume a portion of the risk for a set period, typically 10 years. In return, they get a percentage of the yield.

The investors could suffer losses, or a reduction in their yields, if the loans in the pool default. Generally speaking, the investors have taken on a portion of the first-loss or secondary-loss position. The GSEs assume losses in the event of a catastrophic downturn, and also retain varying percentages of the first-loss and secondary-loss risk positions depending on the tranche. Through these sales, Fannie has laid off risk from about a fifth of its loan portfolio and Freddie about a third, the Urban Institute estimates.  

Kaul said these deals haven’t caused mortgage rates to move because the GSEs charge guarantee fees set by the government, so borrowers have so far been insulated from volatility in the capital markets. In the future, however, depending on the nature of reforms, the mortgage system may have less government involvement and private capital may bear more of the risk. If risk is still primarily transferred by bond sales in the capital market in some new private-sector dominated market, Kaul said, mortgage rates would be much more influenced by the spreads demanded by bond investors. 

“My view on this whole situation is that we are still in the very early stages of risk transfers,” Kaul said. “What I think we need to do is to explore all the different mechanisms for risk transfer that are out there and then refine as we go along based on the feedback that we receive in the marketplace. There is no right answer here. We just need to develop what works and learn as we go along.”  


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