Risk Transfer

As policymakers debate ways to reduce Fannie Mae and Freddie Mac’s role in the U.S. mortgage market, one of the big questions that must be addressed is how much credit risk private investors are willing to take on, and at what price. A new type of security issued by Freddie Mac provides some of the first answers.

Called “Structured Agency Credit Risk,” or STACR [rhymes with ‘slacker’] notes, the securities are unsecured obligations of the government sponsored enterprise; yet their principal repayment is based on the prepayments and defaults on a reference pool of more than $20 billion of residential mortgages acquired by Freddie in the third quarter of 2012. They provide a form of credit enhancement to Freddie, assuming some, but not all, of the risk of the underlying loans.

That makes them unlike any other investment. The bulk of the risk of default on mortgages has always been borne by U.S. taxpayers via the guarantees Fannie Mae and Freddie Mac provide. Before the financial crisis, there was an active non-agency market, but private issuers couldn’t compete with the GSEs for conforming loans, so it was only economical to securitize non-traditional mortgages, notably those made to borrowers with poor credit. The non-agency market is making a comeback but so far investors only have an appetite for securities backed by large loans of very high credit quality.

A big question for investors, particularly those watching from the sidelines, is whether the securities can be scaled to make them sufficiently liquid, or whether this was just the first of several trial balloons. Fannie Mae is said to be working on a risk-sharing transaction of its own that looks very different.

The initial STACR offering, launched late in July, consisted of four tranches: a senior tranche representing 97% of the deal that was retained by Freddie, two privately offered mezzanine tranches representing 1.35% of the deal each, and a 0.3% equity tranche that was also retained by Freddie (though market participants expect Freddie would be happy to unload this exposure as well).

Two mezzanine tranches, which share losses between Freddie 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.

Though offered without benefit of a credit rating, the STACR notes attracted plenty of interest. Freddie increased the combined size of the mezzanine tranches to $500 million from $400 million originally. Some 50 investors participated, including mutual funds, hedge funds, REITS, pension funds, banks, insurance companies, and credit unions.

Credit Suisse was the co-lead book manager and sole bookrunner; Barclays was co-lead manager; Citigroup, Morgan Stanley and CastleOak Securities were co-managers.

Pricing for the M1 tranche was one-month Libor plus 340 basis points; pricing for the M2 transaction was Libor plus 715 basis points.

Edward DeMarco, acting director of the Federal Housing Finance Agency, which has overseen Freddie and Fannie since the companies were seized by the U.S. in 2008, called the transaction “a key step” in the process of attracting private capital back to the U.S. housing finance market.

“We expect to learn from this transaction, refine the approach and maintain steady progress with future transactions to restore private sector participation in housing finance,” DeMarco said.
Freddie Mac CEO Donald H. Layton said it is the GSE’s intent “to create a product that will be well-received by investors and can become repeatable and scalable over time.”

Why issue unsecured debt, with senior and subordinated classes, instead of credit-linked notes? Observers suspect that Freddie wanted to avoid having to register the securities with the Commodities Futures Trading Commission, which has oversight of derivatives. 

A spokeswoman for Freddie said that the STACR offering was company’s “initial approach.” In the future, she said, Freddie “may pursue a more traditional credit linked note using a trust issuer or other types of credit risk transfer transactions.”

The spokeswoman noted that, since the financial crisis, various additional regulations have been proposed and/or implemented governing credit linked notes. “Before doing another type of security, we want to ensure that we would be in compliance with all current regulations,” she said.  
Market participants also point out that STACR notes are similar in structure to a product Freddie offered in 1988; so perhaps it was simpler and more expedient to dust this off rather than start from scratch.

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