Freddie Mac’s $500 million of risk-sharing debt sold yesterday may not give the firm as much protection against homeowner defaults as policy makers seek, according to Amherst Securities Group LP and Deutsche Bank AG.
The structure means that the company would be better off without the securities if refinancing and property sales are initially fast, and then defaults jump amid a real-estate slump, Amherst analysts led by Laurie Goodman wrote today in a report. In addition, it transfers less risk than needed to shield Freddie Mac from all but catastrophic levels of losses among mortgages, according to Deutsche Bank’s Christopher Helwig.
The type of transaction is “an integral part of introducing more private capital to the mortgage market,” the New York-based analyst wrote today in a report. “However, some serious questions still remain.”
The note sale, which was applauded today by the Treasury Department and Federal Housing Finance Agency, reflects an effort to reduce the role of Freddie Mac and Fannie Mae in the residential-mortgage market, where government-backed loans now account for more than 85 percent of lending. The transaction is also similar to the new system of mortgage finance in the U.S. envisioned under bipartisan legislation introduced this year by Republican Senator Bob Corker of Tennessee and Democratic Senator Mark Warner of Virginia.
“We are comfortable with the STACR structure and the credit protection provided,” Kevin Palmer, vice president of costing and portfolio management at McLean, Virginia-based Freddie Mac, wrote in an e-mail, referring to the Structured Agency Credit Risk transaction. “We are still reviewing Amherst’s report.”
The deal was part of an effort to gain insight into how the private sector prices mortgage risk and to reduce taxpayers’ exposure to potential losses, said Edward DeMarco, acting director of the FHFA, which has overseen Freddie Mac and Fannie Mae since the companies were seized by the U.S. in 2008.
“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 in a statement released by the regulator.
Through its deal, Freddie Mac will initially pay about 12 basis points, or 0.12 percentage point, annually for protection against losses on almost $23 billion of loans originated last year, according data compiled by Bloomberg. It collects about 40 basis points for guaranteeing bonds backed by the mortgages, according to the report by the Amherst team run by Goodman, a member of the Fixed Income Analysts Society Hall of Fame.
The transaction was broken into two floating-rate notes of $250 million each, one of which will pay down before the other as homeowners retire or refinance their debt, with both maturing in no later than 10 years.
While repayments will depend on defaults remaining below certain levels, the more-junior bonds will be initially protected against losses of 0.3 percent on the original principal value of the underlying mortgages. The second set will have protection, known as credit enhancement, equal to 1.65 percent and the entire investment would be wiped out after 3 percent, with Freddie Mac bearing additional costs.
In a baseline scenario, defaults on the underlying loans will probably total 66 basis points and holders of both sets of bonds won’t take any losses once fixed recovery rates are taken into account, according to the Amherst analysts. Amid higher defaults and slow loan prepayments the structure would provide “very valuable protection,” allowing Freddie Mac to continue making money on its guarantees, they said.
With higher prepayments, though, “the addition of the risk-sharing structure can create a situation where Freddie earns a negative return on its book of business, rather than a small positive return,” the New York-based analysts wrote.
While that scenario is unlikely for the low-rate, high-quality loans included when housing is recovering and borrowing costs rising, “actions to better protect Freddie Mac against this low-probability event should be contemplated in future deals,” the analysts said.
Policy makers looking to such transactions to protect taxpayers and help set the guarantee fees at Fannie Mae and Freddie Mac may also need to wait for ones that expand the share of losses born by investors, Deutsche Bank’s Helwig wrote.
“To leave Freddie Mac holding only the equivalent of ‘AAA’ risk” the deal would have had to protect the company against losses on about 8.8 percent of the loan balances, according to his estimates.
Michael Stegman, the Treasury secretary’s counselor for housing finance policy, said in an e-mailed statement that the type of deal “helps protect the interests of the American taxpayer, with private capital taking the predominant credit loss -- aligning with the administration’s goal of reducing the government’s footprint in the mortgage market.”