Fannie Woos Investors as Regulators Embrace Risk-Sharing

Fannie Mae, preparing its first sale of securities that would share the risks of homeowner defaults with bondholders, will offer better terms than in Freddie Mac’s initial deal as the U.S.-backed mortgage companies seek to expand investor participation in the market.

Fannie Mae officials are visiting investors across the country, with stops in Boston and Cincinnati this week, as it attempts to sell $675 million of the debt at lower yields than Freddie Mac got in its $500 million offering in July, said three people with knowledge of the sale who asked not to be named because details are private. Under Fannie Mae’s terms, bondholders won’t suffer losses until delinquencies are higher.

U.S. regulators see the notes as a way to reduce the dominance of the two government-controlled firms and assess if they’re charging enough to guarantee their traditional mortgage bonds, embracing a risk-sharing approach that may play a central role in the future of the $9.3 trillion U.S. mortgage market.

“These are the proverbial baby steps,” said Anthony B. Sanders, an economics professor at George Mason University in Fairfax, Virginia, and former head of mortgage-bond research at Deutsche Bank AG.

Fannie Mae’s sale, planned for next month, reflects U.S. attempts to reduce its role, with the current share of new mortgages financed by taxpayer-backed programs at about 85 percent. Fannie Mae and Freddie Mac, which were seized by the U.S. five years ago this month amid the worst housing slump since the 1930s, account for about two-thirds of the market.

Housing Legislation

The risk-sharing transactions resemble provisions included in legislation introduced this year by Republican Senator Bob Corker of Tennessee and Democratic Senator Mark Warner of Virginia, and endorsed by President Barack Obama. The proposal would create an agency to replace Fannie Mae and Freddie Mac that would bear catastrophic mortgage losses, after private firms take the first 10 percent.

The Fannie Mae sale comes as bond investors are seeking new supply because banks are increasingly holding onto other mortgages. After 27 non-government bond deals tied to about $12 billion of new mortgages in the first eight months of 2013, no widely marketed sales have been completed in September, according to data compiled by Bloomberg.

Shellpoint Partners LLC, the lender backed by mortgage-bond pioneer Lewis Ranieri, has delayed its second offering, which had been planned for this month, leaving only PennyMac Mortgage Investment Trust seeking a sale, according to two people with knowledge of the matter.

This year’s transactions are up from $3.5 billion in all of 2012, though down from the record of about $1.2 trillion in each of 2005 and 2006.

FHFA Seeks

The Federal Housing Finance Agency, Fannie Mae and Freddie Mac’s regulator, has sought risk-sharing deals among steps meant to shrink the mortgage companies and depend more on private investors as the U.S. Federal Reserve weighs reducing its unprecedented stimulus and the government cuts federal spending.

Andrew Wilson, a spokesman for Washington-based Fannie Mae, declined to comment on the terms of its planned transaction.

“We are working with FHFA to meet the goals of the conservatorship scorecard for 2013,” said Wilson, referring to targets guiding Fannie Mae and Freddie Mac executive bonuses that seek risk-sharing on $20 billion of mortgages each.

Fitch Ratings

Bank of America Corp.’s Merrill Lynch unit, which is jointly managing underwriting of the Fannie Mae bonds with Credit Suisse Group AG, is helping structure the deal. Zia Ahmed, a spokesman at the bank, declined to comment. The deal also is expected to differ from Freddie Mac’s unrated notes by getting a grade of BBB- on a slice from Fitch Ratings, the people said.

Fannie Mae is calling its new bonds Connecticut Avenue Securities, after a street in Washington where one of its offices is located. Freddie Mac named its notes Structured Agency Credit Risk, or STACR, securities, and said it found almost 50 different buyers, including mutual funds, hedge funds, real-estate investment trusts, pension funds, insurers, banks and credit unions.

“The STACR issuance was small relative to the size of Freddie Mac’s balance sheet, but we believe it serves as an important step in the transition toward broader private participation in the U.S. mortgage finance market,” Fitch analysts Ilya Ivashkov and Bill Warlick wrote last month in a statement.

Repeatable Offering

Freddie Mac officials are now “working on our second STACR transaction and hope to complete it this year and plan to have it rated,” Patti Boerger, a spokeswoman, said in an e-mail. “Our goal is to have a programmatic, repeatable and standardized offering with STACR.”

The McLean, Virginia-based company is “also looking at doing other types of credit risk-sharing transactions this year,” she said. In July, Fannie Mae obtained insurance on a pool of about $5 billion of mortgages from National Mortgage Insurance Corp. as part of its risk-sharing effort.

Bond investors have bid up the Freddie Mac notes since they were sold. One slice traded on Sept. 23 at a price of more than 101 cents on the dollar, or a spread over the one-month London interbank offered rate of less than 2.90 percentage points, according to data provider Empirasign Strategies LLC. That’s down from a spread of 3.4 percentage points at issuance.

Less Protection

While the Treasury Department joined the FHFA in applauding the Freddie Mac sale as a good first step, Amherst Securities Group LP and Deutsche Bank AG analysts said that the notes might not offer as much protection against homeowner defaults as policy makers seek, based on the deal’s structure or the amount of risk shared.

The Fannie Mae notes will be unsecured obligations of the company rather than traditional mortgage-backed securities, the same as the Freddie Mac offering. The return of their principal will be tied to $28.1 billion of loans made during the third quarter of 2012.

The deal is broken into two parts of $337.5 million each, one of which will pay down before the other as homeowners retire or refinance their debt. The more-junior bonds will be initially protected against losses of 0.3 percent on the principal value of the underlying mortgages. The second set will have that amount of protection, known as credit enhancement, equal to 1.65 percent and the entire investment would be wiped out after 3 percent, with Fannie Mae bearing additional costs.

Protection Eroded

The protection will be eroded every time a borrower falls delinquent by 180 days, gets permission to sell a home for less than is owed and similar events, including foreclosures. The balance of the debt then will be multiplied by a number that starts at 10 percent and can rise to 20 percent and then to 40 percent, depending on how many defaults already occurred.

In Freddie Mac’s deal, the multiplier started at 15 percent for defaults of less than 1 percent, rose to 25 percent until defaults reached 2 percent and then became 40 percent. The lower starting figures planned in the Fannie Mae deals mean that more loans will need to sour before investors suffer losses.

Holders of the Fannie Mae securities also can get their money back faster than in the Freddie Mac deal as borrowers refinance or move, reducing the risks of a spike in defaults later in the life of the bonds, because Fannie Mae’s won’t include a loan-performance test used by Freddie Mac.

Taxpayer Aid

Freddie Mac’s debt will shut off most principal payments to bondholders if defaults exceeded certain levels. For instance, if defaults exceed 0.25 percent before July 2014, or 1 percent by July 2017, investors would receive less in repayments. The Fannie Mae bonds cut off prepayments to bondholders when it has protection of less than 3 percent of current loan balances.

Under the FHFA’s direction, Fannie Mae and Freddie Mac are seeking to lower their future risks after returning to profitability following almost $190 billion of taxpayer-funded capital injections.

Illiquid Holdings

The firms also have been told by the FHFA to try to sell $39 billion of illiquid holdings this year, reduce their total portfolios and increase what they charge to insure new bonds. The FHFA also is weighing lowering the size of loans they can finance, according to analysts at Barclays Plc.

Banks including Wells Fargo & Co. have been squeezing bond issuers out of the jumbo market by offering the loans at rates lower than available on traditional mortgages. The San Francisco-based lender has said it also has retained more than $20 billion of loans since mid-2012 that could have been packaged into Fannie Mae and Freddie Mac bonds.

Fannie Mae and Freddie Mac may not want to do too well at luring bond investors to their risk-sharing deals, according to Sanders, the former bond analyst and professor.

“I think that they’re nervous about succeeding, because if they succeed that gives a lot of people in Congress the ability to say, ‘Well, we don’t need them after all do we?’” he said.