Bespoke Tranche Opportunity: It’s déjà vu all over again
Can Civility in Society Be Regained?

Fannie Mae and Freddie Mac Returning to Risky Investments

It's Back to the Future for Government-Sponsored Mortgage Entities

The Federal National Mortgage Association (Fannie Mae) and the Federal Home Loan Mortgage Corporation (Freddie Mac) are government-sponsored entities that make money either by buying, guaranteeing, and then reselling home mortgages for a fee or by buying mortgages, holding them, and then taking on the risk. Fannie and Freddie got caught up in the financial disaster of 2007-2008 when it bought/guaranteed subprime mortgages that went south. Were they to blame in taking on the risk? Did they play fast and loose with taxpayer dollars? You betcha and it cost taxpayers $187 billion, an amount the government “claims” has been paid back.

Last week I wrote about the exotic “bespoke tranche opportunity”, a new device that allows investors to target very specific risk/return profiles for their investment strategies or hedging requirements. In reality, the arranger demands a good deal of input into the selection of the reference portfolio. Most investment managers control their risks by buying and selling protection on a single-name credit default swap by linking losses to a corporate credit index like the CDX or iTraxx; therefore, they usually avoid taking positions in CDSs that cannot readily be traded.

You know the old saying: “If it walks like a duck, talks like a duck, then it’s a duck, or in this case another risky investment strategy that may, eventually, lead to another financial meltdown. Well, guess what? Fannie and Freddie want in on the action.

Fannie Mae and Freddie Mac are turning to crisis-era tools to reduce their exposure to mortgage losses and spark a new market for financing home buyers. Beginning this year, the two government-controlled housing giants will ramp up sales of a new type of security that will transfer most of the cost of defaults on all but their safest mortgages to private investors. The securities will be based on the value of a pool of underlying mortgages—but only indirectly, making them a derivative similar to those that figured in the financial crisis seven years ago.

The insurance-like products are called Connecticut Avenue Securities [where do they get these names] by Fannie Mae and Structured Agency Credit Risk by Freddie Mac. This marks a return to financial engineering in housing finance—elements of which served useful purposes before bloating in the years leading to the crisis.

The new securities ultimately could help reduce the government’s role in mortgages by persuading investors to take on the risk of default. Right now, the U.S. housing market relies almost entirely on guarantees from Fannie, Freddie or other government-backed entities. The companies, along with government agency Ginnie Mae, back most mortgages and issued 96% of all mortgage bonds in the first 10 months of 2015, according to trade publication Inside Mortgage Finance.

Proponents hope the new securities could help restore investors’ appetite for mortgage risk. If it works, backers think the securities could become a mainstay of the bond and housing markets over time, perhaps even getting included in the major indexes tracked by bond funds.

“To many people, mortgage credit risk is still a bad word,” said Laurie Goodman, director of the Housing Finance Policy Center at the Urban Institute, adding that she isn’t optimistic that the market for privately backed mortgage bonds will revive soon. Let’s hope investors are smart enough to think twice before investing in something they may not understand – and neither may their investment advisers.

Fannie and Freddie already have sold about $25 billion of the securities since 2013 to private investors, including money managers such as Black Rock Inc. and Invesco Ltd., hedge funds, real-estate investment trusts and other investors.

Earlier this month, the Federal Housing Finance Agency, which regulates Fannie and Freddie, set a goal for the companies to transfer most of their risk on many of the new mortgages they back to private investors. The guidance covers mortgages of more than 20 years where homeowners make less than a 40% down payment and says the companies should lay off the risk on 90% of the unpaid principal balance.

Fannie and Freddie don’t make loans. They buy them from lenders, wrap them into securities and guarantee to make investors whole if the mortgages default.

In practice, that has meant that investors have taken on the risk of losses if interest rates rise but have left the government with the risk if borrowers default. The new securities—along with other methods Fannie and Freddie use to lay off risk—mean that the government is increasingly transferring that default risk to private investors as well.

The new securities allocate the risk of default to different tranches [not that word again]. The housing giants typically hold the safest tranche and the riskiest tranche. Investors can buy those in the middle based on their risk and return appetites.

I’ve seen this picture before. It’s called The Big Short. You know the old saying: Those who fail to learn from history are doomed to repeat it again.

Blog posted by Dr. Steven Mintz, aka Ethics Sage, on January 5 2016. Professor Mintz is on the faculty of the Orfalea College of Business at Cal Poly San Luis Obispo. He also blogs at: