Freddie Mac's burgeoning efforts to offload credit exposure to private investors through its innovative risk-sharing transactions highlight a growing tension between its financial results and regulatory risk management goals.
The government-sponsored enterprise reported a quarterly loss for the second time in four years Tuesday. The results were largely influenced by low interest rates, which have a negative effect on derivative hedges and other balance-sheet assets. But it serves as a reminder that the reduction in the GSEs' credit risks and size will increasingly put Freddie, as well as Fannie Mae's, profits at risk.
"Credit risk sharing decreases the amount of risk that the GSEs have from changing economic environments … but at the same time, it actually reduces their net income," explained Andrew Davidson, an industry analyst and consultant who helped develop the structure for some of the GSEs' risk-sharing products.
Because Freddie's net worth remains above minimum targets, it did not need to request a draw from its line of credit with the Treasury Department following rate-related net losses it posted in the first quarter of 2016 or the third quarter of 2015, each of which totaled hundreds of millions of dollars.
Quarterly earnings tend to put a focus on the increased risk of Freddie needing additional bailout funds, but they don't as clearly reflect the offsetting and more long-term reduction in credit risk exposure as a result of post-crisis reforms.
After needing more than $71 billion in draws from the Treasury from 2008 to 2012, Freddie Mac has been profitable in the years since. Dividend payments to the Treasury peaked at more than $47 billion in 2013 and have since fallen dramatically, totaling more than $5 billion in 2015. While it doesn't count toward paying down the draws, Freddie Mac has made $98.2 billion in dividend payments to the Treasury since 2008, $26.9 billion more than it has received.
And in the absence of new efforts at GSE reform, current plans call for Fannie and Freddie to shrink their portfolios to the point where they have a zero net worth in 2018, leaving no buffer against losses, notes Tim Rood, chairman of the Collingwood Group financial consultancy and a former Fannie Mae executive.
"Each year the can is kicked down the road, the situation becomes more dire," he said.
The new forms of credit risk sharing Freddie Mac has been experimenting with remain smaller in scope than the mandatory risk-sharing the GSEs traditionally have done through private mortgage insurance on high loan-to-value ratio mortgages, but they are "growing rapidly," said Freddie Mac CEO Donald Layton.
"The actual amount of loss we would not have to absorb…is a little over $18 billion," he said during a conference call with reporters Tuesday.
Roughly 40% of total credit risk from new loans Freddie purchased in 2014 was shed via risk sharing deals and mortgage insurance, Davidson said. However, that remains a small fraction of the GSE's total book of business.
Davidson estimated Fannie Mae, which will release its first-quarter results on May 5, might be similar, though he noted that Fannie has done fewer risk-sharing deals relative to its larger book of business. And Fannie may have a little more leeway than Freddie. During the third quarter last year it also took a hit due to the rate environment, but was able to remain profitable because of the composition of its balance sheet and larger size.
Whether the GSEs' risk-sharing efforts are worth the rising risk to profitability will be up to Washington decision makers. Layton has said Freddie Mac is examining ways to reduce its earnings volatility, but declined to specify how. So far, the Federal Housing Finance Agency and credit rating analysts don't appear to be overly concerned about it yet. But the FHFA continues to show impatience with the lack of action on GSE reform.
"The loss reported today by Freddie Mac does not reflect a decrease in the credit quality of the mortgages it backs. Rather, like the loss reported in the third quarter of 2015, it resulted from significant volatility in interest rates and the impact of the accounting rules that apply to activities designed to hedge against such interest rate movements," FHFA Director Mel Watt said in a May 3 statement. "We have repeatedly warned that this combination could result in losses and that these losses could result in the possibility of draws as the capital buffers for Freddie Mac and Fannie Mae are reduced over time."