Academic journal article Federal Reserve Bank of New York Economic Policy Review

Credit Risk Transfer and De Facto Gse Reform

Academic journal article Federal Reserve Bank of New York Economic Policy Review

Credit Risk Transfer and De Facto Gse Reform

Article excerpt

Nearly a decade into the conservatorships of Fannie Mae and Freddie Mac, no legislation has yet been passed to reform the housing finance system and resolve the long-term future of these two government-sponsored enterprises (GSEs). However, the GSEs have implemented significant changes in their operations and practices over this period, even in the absence of legislation. (1) The goal of this paper is to summarize and evaluate one of the most important of these initiatives--the use of credit risk transfer (CRT) instruments to shift mortgage credit risk from the GSEs to the private sector. (2)

Fannie Mae and Freddie Mac have significant mortgage credit risk exposure, largely because they provide a credit guarantee to investors on the agency mortgage-backed securities (MBS) they issue. Since the CRT programs began in 2013 through December 2017, Fannie Mae and Freddie Mac transferred to the private sector a portion of the credit risk on approximately $1.8 trillion in single-family mortgages (Fannie Mae 2017; Freddie Mac 2017a). The GSEs have experimented with a range of risk transfer instruments, including reinsurance, senior-subordinate securitizations, and transactions involving explicit lender risk sharing. However, as shown in Exhibit 1, the bulk of CRT has occurred through issuance of structured debt securities whose principal payments are tied to the credit performance of a reference pool of securitized mortgages. A period of elevated mortgage defaults and losses would trigger automatic principal write-downs on these CRT bonds, partially offsetting GSE credit losses.

Our thesis is that the CRT initiative has improved the stability of the housing finance system and advanced a number of important objectives of GSE reform. In particular, the CRT programs have meaningfully reduced the federal government's exposure to mortgage credit risk without disrupting the liquidity or stability of secondary mortgage markets. In the process, the CRT programs have created a new financial market for pricing and trading mortgage credit risk, which has grown in size and liquidity over time. Given diminished private-label securitization in recent years, these CRT securities are one of the primary ways for private sector capital market investors to gain exposure to residential mortgage credit risk.

An important reason for this success is that the credit risk transfer programs do not disrupt the operation of the agency MBS market or affect the risks facing investors in agency MBS. Because agency MBS carry a GSE credit guarantee, agency MBS investors assume that they are exposed to interest rate and prepayment risk, but not credit risk. This feature reduces the set of parameters on which pass-through MBS pools differ from one another, thereby improving the standardization of the securities underlying the liquid to-be-announced (TBA) market where agency MBS mainly trade. (3) Even though the GSEs now use CRT structures to transfer credit risk to a variety of private sector investors, these arrangements do not affect agency MBS investors, since agency MBS credit guarantees are still being provided only by the GSEs. In other words, the GSEs stand between agency MBS investors and private sector CRT investors, acting in a role akin to a central counterparty.

Ensuring that the GSEs' efforts to share credit risk occur independently of the agency MBS market is important for both market functioning and financial stability. The agency MBS market, which remains one of the most liquid fixed-income markets in the world, proved resilient during the 2007-09 financial crisis, helping support the supply of mortgage credit during that period. The agency market financed $2.89 trillion in mortgage originations during 2008 and 2009, experiencing little drop in secondary market trading volume (Vickery and Wright 2013). In contrast, the non-agency MBS market, in which MBS investors are exposed directly to credit risk, proved to be much less stable. …

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