Transferring Credit Risk on Mortgages Guaranteed by Fannie Mae or Freddie Mac
CBO reviews Fannie Mae and Freddie Mac’s program to transfer some of the credit risk of their guarantees to investors and analyzes two approaches for expanding those efforts.
Fannie Mae and Freddie Mac are government-sponsored enterprises (GSEs) that help finance mortgages in the United States. They were originally established by the federal government as private corporations with a public mission. However, in September 2008, the government placed the GSEs in conservatorships under their regulator, the Federal Housing Finance Agency (FHFA), because of financial distress stemming from the recession that began in 2007.
Today, under those conservatorships, the debt securities and mortgage-backed securities (MBSs) that Fannie Mae and Freddie Mac issue are effectively guaranteed by the federal government (subject to limits). That guarantee explicitly exposes the government to risk from the activities of the GSEs.
Fannie Mae and Freddie Mac operate mainly in the secondary (or resale) market for single-family mortgages. They buy mortgages that meet certain standards from banks and other mortgage originators; pool those loans into mortgage-backed securities, which they guarantee against most of the losses from defaults on the underlying mortgages; and sell the MBSs to investors—a process known as securitization. The GSEs’ guarantees on MBSs provide insurance to investors that they will receive payments of principal and interest on the underlying mortgages even if a borrower defaults. Some of the other losses from defaults on those mortgages are borne by private mortgage insurers. However, on most of the loans pooled into MBSs, the GSEs—and thus the federal government—bear a significant share of the risk of losses as part of their traditional guarantee operations.
How Do the GSEs Share Risk With Private Investors?
At the direction of FHFA, the GSEs began undertaking transactions in 2013 to transfer some of the credit risk of their guarantees to private investors. In most of those transactions, the GSEs issue bonds, called credit-risk notes, that pay principal and interest to investors based on the performance of an underlying pool of mortgages guaranteed as part of traditional MBSs. Credit-risk notes insulate Fannie Mae and Freddie Mac from a specified amount of mortgage losses by having those losses reduce the amount of principal repaid to holders of the notes. The GSEs have also experimented with reducing their exposure to credit risk by issuing subordinate MBSs that they do not guarantee, by having mortgage originators retain some of the risk on the loans sold to the GSEs, and by purchasing reinsurance on pools of mortgages.
How Are the GSEs’ Risk-Sharing Transactions Working?
CBO examined how the GSEs’ use of credit-risk-transfer (CRT) transactions has been operating under current policy and concluded the following:
- Current CRT transactions are being executed in a fully functioning liquid market, and the GSEs use a competitive process to determine the price they will pay private investors to accept the risk being transferred. Although those transactions generate administrative expenses for the GSEs, they do not change the GSEs’ fair-value subsidy cost. (Fair value is a market-based measure of the federal government’s obligations and is the measure that CBO uses to estimate the subsidy cost of Fannie Mae and Freddie Mac in the federal budget.)
- Currently planned CRT transactions are projected to reduce the GSEs’ exposure to risk by $2.8 billion in 2018. That amount is equal to 11 percent of the total risk exposure from the GSEs’ new guarantees in that year, CBO estimates. (In this analysis, CBO evaluates risk exposure using a fair-value measure of losses from defaults that implicitly puts more weight on losses that occur in adverse economic conditions.)
- If the economy performs as CBO projects in its January 2017 baseline macroeconomic forecast, the currently planned CRT transactions will reduce the GSEs’ total net premium income on their 2018 guarantees. The reason is that, under normal economic conditions, the GSEs will pay more in interest to CRT investors than they will receive in protection from losses. The situation may be different if the economy experiences more challenging conditions, such as a severe recession. In that case, the GSEs’ net premium income may be higher with CRT transactions than it would be otherwise, meaning that the GSEs will receive more in protection than they will pay in interest. (Net premium income is defined here as the GSEs’ collections of premiums for their guarantees net of interest paid to the investors involved in CRT transactions and net of losses borne by the GSEs in excess of losses borne by CRT investors.)
How Could the GSEs Expand Their Risk Sharing?
CBO also analyzed two approaches for expanding the GSEs’ efforts to share risk with investors: increasing the amount of risk shared on new mortgages guaranteed in the future, and transferring some of the risk on mortgages guaranteed before 2013, when the current CRT program began. CBO concluded that expanding the GSEs’ use of credit-risk transfers in those ways would have the following effects:
- Produce no change in the fair-value subsidy cost of the GSEs;
- Further reduce the GSEs’ risk exposure in 2018; and
- Further reduce the total annual net premiums collected by the GSEs on their guarantees, compared with net premium income in the absence of risk sharing, if the economy performs as CBO projects in its baseline macroeconomic forecast, or further increase net premium income (relative to not conducting credit-risk transfers) under a scenario of economic stress.