Friday, October 12, 2012

Fannie Mae, Freddie Mac and risk-sharing bonds

In yet another effort to restart the private mortgage finance market, Fannie Mae and Freddie Mac are trying to offer risk-sharing bonds.  These are bonds backed by mortgages where private investors would absorb some of the loss if the underlying mortgages don't perform.

Who would buy these bonds in the absence of observable event based reporting so that as investors they always know what they own?

Without information on the activities like payments and defaults on the underlying mortgages being reported before the beginning of the next business day, buying these bonds is simply blindly betting.

As reported by the Wall Street Journal,

Federal officials are running into an unexpected roadblock as they try to bring private money back to a U.S. mortgage market now dominated by the government, according to people familiar with the matter. 
Fannie Mae (FNMA) and Freddie Mac (FMCC), the government-controlled mortgage finance giants, were supposed to issue a new class of mortgage securities by Sunday, according to plans set by their regulator. But they missed this goal, partly because it became clear that new regulations under the Dodd-Frank Act were complicating the debt offering. 
The new securities, known as risk-sharing bonds, would offer a higher yield than standard mortgage bonds in return for bearing losses when loans go bad. 
For private investors, that would increase the risk but also the reward from the current system, in which the two taxpayer-supported firms guarantee investors receive payments even when borrowers default....
Without observable event based reporting, it is impossible to assess the risk of these bonds in the secondary market and therefore know if the return is adequate for the risk being taken on.
The plan for new securities was developed by the Federal Housing Finance Agency and Treasury Department, but their future may rest with the Commodity Futures Trading Commission....
Michael Stegman, a senior Treasury adviser for housing finance, in June said the risk-sharing initiative "could help support our broader efforts to restart the private mortgage market, shrink the government's footprint in housing finance, and protect the long-term interests of taxpayers." 
In addition, the initiative would help determine how the private market would value the guarantee provided by Fannie Mae and Freddie Mac, the FHFA said in its 2011 report to Congress.
Since the Treasury Department is involved, we can rest assured that Wall Street is driving the development of these bonds.

Given that no one will touch a new private mortgage deal, it is not surprising to see Wall Street try for a 'hybrid' deal:  part government guaranteed and part blind bet.

If Wall Street can find gamblers for these hybrid securities, it will try to slowly increase the percentage of the deal that is blind bet in the hope that buyers will have amnesia and not remember they lost a lot of money blindly betting on mortgage-backed securities.

Fortunately, the National Association of Insurance Commissioners' white paper on the future of mortgage finance foresaw this type of hybrid security.  That is why it established the principal of linking capital to disclosure.  Specifically, low capital requirements for deals that provide observable event based reporting and prohibitively high capital requirements for deals that don't.

1 comment:

Anonymous said...

The CFTC waived the regulation for asset backed securities.

So not sure what excuse the FHFA is going to use now.

As you rightly correctly point out no one is going to touch a private mortgage.