The recent risk-sharing transaction from Freddie Mac offers several lessons that should inform the debate about the future of housing finance and the government-sponsored enterprises.
The first lesson is that there's a lot more work, and imaginative thinking, to be done. True, by offloading the credit risk on a $22.5 billion reference pool of mortgages, the deal – the first in a series of risk transfers mandated by the Federal Housing Finance Agency – goes a long way toward Freddie's goal of shedding $30 billion of risk this year. But Structured Agency Credit Risk is a one-off structure. It is not possible to assess any relative value between this senior-subordination structure and alternative credit risk-sharing arrangements. Lacking a systematic set of success criteria by which to compare and evaluate alternative structures, the risk-sharing initiative misses an opportunity to better inform congressional debate on the future of the housing finance system.
Moreover, although Freddie's CEO would like to make STACR a "repeatable and scalable" process, the use of Freddie's existing securitization infrastructure greatly reduces the chances for that to occur. To be fair, such structures cannot wait for the FHFA's proposed common securitization platform to be built. But scalability is an open question under existing GSE infrastructure.
The second lesson is that the potential for structural arbitrage remains alive and well in the capital markets. One has to wonder why Freddie Mac went with STACR as an unsecured general obligation, with senior and subordinated classes, rather than as a credit-linked note – the more obvious, intuitive structure for a risk-sharing, credit derivativelike transaction. It may well be that Freddie did this to avoid triggering burdensome regulatory requirements for derivatives that would have applied had it issued a credit-linked note. The Commodity Futures Trading Commission has outlined certain exemptions from registration requirements as a commodity pool for certain types of securitizations. However, in the case of CLNs, where credit protection could be sold or some credit risk retained via a swap arrangement, the structure could trigger treatment as a commodity pool, which comes with greater regulatory requirements.
To the extent that was a factor in the decision making for the STACR transaction, it shows how regulation might lead to unintended consequences – in this case, CFTC registration requirements can be avoided by creative financial engineering.
The final lesson from the STACR structure is that the catastrophic guarantee outlined in the Corker-Warner GSE reform bill might be nil in effect.
The structure consists of a senior tranche retained by Freddie Mac of about $22 billion, representing 97% of the reference pool. Two mezzanine tranches, which share losses between Freddie Mac and private investors, combined with a smaller junior tranche retained by Freddie, provide the senior tranche with credit protection against the first 3% of losses on the pool. This is interesting given that the Corker-Warner bill states that the private first-loss position is not to be less than 10% of the principal amount.
The pool is of such high credit quality (and reinforced by the Qualified Mortgage rules) that according to my estimates, lifetime losses for the STACR collateral would be perhaps 15 to 25 basis points in a base case scenario and 3% to 5% in a stressed situation like the mortgage crisis.
Assuming that the reference pool is representative of the kind of loans we're likely to see in a post-GSE world where QM is the standard, taxpayers should be able to rest easy under a Corker-Warner plan. The likelihood of ever tapping the catastrophic guarantee seems an extremely remote possibility with loans like these. While it might not ameliorate the ideological issue of having a federal guarantee, it certainly appears that setting the threshold for the public guarantee to kick in after 10% makes the debate between the House GOP and Senate seem moot.
Despite these macro reservations regarding the STACR transaction, it is important to remember that on a micro level, the structure serves its intended purpose of shedding credit risk from Freddie's balance sheet in a structure that has value to private investors. Under likely higher interest rate conditions that reduce the prospect for loan prepayments and all but very stressful credit conditions, private investors should find the structure produces reasonable if not stellar returns. Still, the opportunity to learn from these structures in a broader context should not be lost on the GSEs or the FHFA.
Clifford Rossi is the Executive-in-Residence and Tyser Teaching Fellow at the Robert H. Smith School of Business at the University of Maryland.