FHFA Statement on Housing Reform, Fundamentals of Credit Risk Transfers
On December 10, the Federal Housing Finance Agency (FHFA) released a statement by Deputy Director of the Division of Conservatorship, Wanda DeLeo, before the U.S. Senate Committee on Banking, Housing, and Urban Affairs titled Housing Finance Reform: Fundamentals of Transferring Credit Risk in a Future Housing Finance System.
“Housing Finance Reform: Fundamentals of Transferring Credit Risk in a Future Housing Finance System”
Chairman Johnson, Ranking Member Crapo, and members of the Committee,
my name is Wanda DeLeo and I am the Deputy Director of the Office of Strategic
Initiatives at the Federal Housing Finance Agency(FHFA). Thank you for the
opportunity to appear before you today to discuss the credit risk transfer activities
we have asked Fannie Mae and Freddie Mac, or the Enterprises as I will refer to
them, to participate in, particularly securities market sales of credit-linked debt
instruments. I’d like to start by recognizing the important work this Committee has
undertaken to redesign the nation’s housing finance structure, including specifically
the current work of the Chairman and Ranking Member, the efforts of Senators
Corker and Warner, and those of their cosponsors, as well. We remain eager to
help in any way we can.
More than five years into conservatorship, the Enterprises continue to provide funding
for roughly two-thirds of all new mortgages. Combined with direct government
guarantees through FHA and VA, this amounts to roughly 90 percent of new loans
being supported by the federal government. Enterprise losses since the financial crisis
in 2008 required the Treasury to inject $187.5 billion of capital into those companies.
While the new loans they insure or guarantee are of much higher quality than those
that led to most of the losses, it is prudent to seek alternative funding mechanisms
that place less potential burden on taxpayers. Our credit risk transfer program is
designed to do exactly that.
Improved housing market conditions, coupled with policy changes and strong efforts of
staff of both Enterprises to address still serious deficiencies in their business
operations, have enabled a welcome return to profitability. But that should not blind us
to the very real costs associated with the Enterprises’ failures. The dividends they have
paid to the Treasury reflect not a return of capital, but payment for the extraordinary
risk the government was forced to take in view of the potential at the time for economic
disaster. The current earnings are only possible because of the Treasury investment;
no one even today would be purchasing Enterprise debt in the absence of it.
It is in keeping with FHFA’s responsibilities as conservator to minimize taxpayer risks
while helping to ensure the secondary mortgage market continues to serve its
functions. At the same time, we are seeking to develop standards, norms, experience,
and private investment capacities that can continue into the future of a new secondary
market structure. Credit risk transfers can help us simultaneously in all three of our
broad conservatorship goals: build, contract, and maintain. Accordingly, we have set a
target for each of the Enterprises to conduct multiple types of risk sharing transactions
involving single family mortgages with a total of at least $30 billion of unpaid principal
balances in 2013. We specified that the transactions be economically sensible,
operationally well-controlled, transparent to the marketplace, and involve a meaningful
transference of risk. Further, we informed the Enterprises that our evaluation for
assessing their performance on FHFA’s conservatorship scorecard objectives will also
consider the utility of the transactions to furthering the long-term strategic goal of risk
transfer. We will make final judgments later this year, but clearly the transactions
completed this year have accomplished a great deal.
The Enterprises have initially focused on two broad categories of credit risk sharing transactions. One transaction category is pre-funded capital markets transactions, which include Freddie Mac’s Structured Agency Credit Risk securities (STACRs) and Fannie Mae’s Connecticut Avenue Securities (C-deals). In these transactions, investors buy debt securities that offer relatively higher returns if the credit performance of loans in a reference pool is good, but may lose principal when credit performance deteriorates. There is no counterparty risk for the Enterprises because when investors buy the securities, they are putting up cash that covers their maximum losses. This approach offers efficient, competitive, market pricing of risk. It also spreads risk across many investors with varying degrees of leverage, and with varying degrees of risk concentration in mortgages. Less risk concentration and less leverage has the potential to reduce systemic risk relative to past and current practices that channel the bulk of the risk into a very small number of highly leveraged institutions, such as the Enterprises. A possible downside is that overreliance on this approach may leave the market for risk more prone to price change in response to changing market conditions.
The other transaction category for this year’s Enterprise transactions is insurance or guarantee agreements. In these, a mortgage insurer, re-insurer, or other guarantor pays claims in the event of loss. These deals can take advantage of such firms’ mortgage expertise and dedicated capital, and they may be less quick to leave the market during a temporary market disturbance, especially one not directly related to housing markets. However, this approach involves more counterparty risk, more vulnerability to housing market weakness when the counterparties are not diversified, and a more limited set of bidders for the risk.
In both types of transactions, the Enterprises essentially use a portion of their guarantee fee income from the reference pool to purchase credit protection, either through higher interest rates paid on the capital market transactions, or though premiums paid to insurance companies. FHFA worked closely with the Enterprises on each of this year’s transactions, and in each case was confident that conservatorship goals would be served. Reaching this point required strong efforts by many over an extended period of time, and I want to recognize the excellent work of the staffs of Fannie Mae and Freddie Mac, including those sitting beside me today.
Please click here to view the statement in its entirety.
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