There are still steps Fan­nie Mae and Fred­die Mac can take to max­i­mize sec­ondary mar­ket liq­uid­ity and broaden the in­vestor bases.

National Mortgage News - - Contents - By brad finkel­stein

GSE credit risk trans­fer pro­grams are a hous­ing re­form model

the suc­cess of the gov­ern­ment- spon­sored en­ter­prises’ credit risk trans­fer pro­grams shows that they can be the ba­sis for hous­ing fi­nance re­form.

But there are still steps that can be taken to max­i­mize sec­ondary mar­ket liq­uid­ity and broaden the in­vestor bases, ac­cord­ing to a pa­per co-writ­ten by An­naly Cap­i­tal Man­age­ment and the Fed­eral Re­serve Bank of New York.

The var­i­ous pro­pos­als for hous­ing fi­nance re­form gen­er­ally share two com­mon goals: en­sur­ing that mort­gage credit risk is borne by the pri­vate sec­tor, and main­tain­ing the cur­rent se­cu­ri­ti­za­tion in­fra­struc­ture as well as the stan­dard­iza­tion and li- quid­ity of agency mort­gage-backed se­cu­ri­ties mar­kets, said the pa­per’s au­thors, An­naly’s Chief In­vest­ment Of­fi­cer David Finkel­stein, its Di­rec­tor of Macro Strat­egy An­dreas Str­zodka, and James Vick­ery, FRBNY’s as­sis­tant vice pres­i­dent in the re­search and statis­tics group. “The credit risk trans­fer pro­gram, now into its fifth year, rep­re­sents an ef­fec­tive mech­a­nism for achiev­ing these twin goals.”

Through De­cem­ber 2017, Fan­nie Mae and Fred­die Mac had trans­ferred $62 bil­lion of the credit risk on $1.8 tril­lion of mort­gages us­ing var­i­ous struc­tures.

But when it comes to broad­en­ing the in­vestor base, the au­thors ar­gued against the GSEs sell­ing the first-loss piece and cat­a­strophic risk pieces of the risk-shar­ing se­cu­ri­ties.

Trans­fer­ring the first-loss piece is un­likely to lead to any over­all net losses for the GSEs af­ter tak­ing into con­sid­er­a­tion the guar­an­tee fee in­come earned on the un­der­ly­ing mort­gages. It is also of lim­ited ben­e­fit from a risk man­age­ment stand­point and it gives the GSEs skin in the game “which may help at­tract in­vestors and mit­i­gate mo­ral haz­ard.”

Fi­nally, “some pri­vate in­vestors may face high cap­i­tal costs from hold­ing first-loss tranches,” the re­port said.

Sim­i­larly, the GSEs would see lit­tle risk man­age­ment ben­e­fit from sell­ing the cat­a­strophic risk piece. What they should con­cen­trate on is what they are cur­rently do­ing: trans­fer­ring the mez­za­nine credit risk as­so­ci­ated with their guar­an­tee port­fo­lio, the re­port said.

Front-end risk trans­fers could elim­i­nate some of the time lag as­so­ci­ated with the cur­rent pro­gram, but the trade-off is a smaller in­vestor base.

“This more lim­ited in­vestor uni­verse should make for less ef­fi­cient ex­e­cu­tion, in turn rais­ing the pre­mium for the credit risk. From a broader fi­nan­cial sta­bil­ity per­spec­tive, this ap­proach also im­plies less sys­tem-wide di­ver­si­fi­ca­tion of mort­gage credit risk, given that mort­gage orig­i­na­tors, like the GSEs, are sig­nif­i­cantly ex­posed to the hous­ing mar­ket and are also of­ten highly lever­aged,” the re­port said.

What will broaden the in­vestor base is re­mov­ing the reg­u­la­tory un­cer­tainty re­gard­ing whether real es­tate in­vest­ment trusts and in­sur­ers can pur­chase these as­sets.

“We note that the CRT pro­grams have not yet been tested by an ad­verse macroe­co­nomic en­vi­ron­ment, and we can­not be cer­tain how CRT in­vestor de­mand and pric­ing will evolve un­der such con­di­tions. Care­ful man­age­ment of the pro­grams will likely be needed dur­ing such an episode. As we dis­cuss, there are also a sev­eral out­stand­ing ques­tions about the de­sign of CRT in­stru­ments, and how to max­i­mize sec­ondary mar­ket liq­uid­ity and en­hance the breadth of the in­vestor base. The credit risk trans­fer pro­grams will con­tinue to grow and evolve in re­sponse to these con­sid­er­a­tions,” the re­port said.

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