Far Less Than Meets the Eye

As a follow-up to my proposal for the Urban Institute’s Housing Finance Reform Incubator series, which I called “Fixing What Works,” I’ve been examining whether having a credit guarantor use risk-sharing securities behind a layer of first-loss equity capital—or sandwiched between layers of equity capital—might provide credit protection more cost-effectively than equity capital used exclusively.

During the course of this exercise I read the 213-page prospectus for Fannie Mae’s July 2016 Connecticut Avenue Securities (CAS) risk-sharing transaction, to better understand the details of how these deals work. Much to my surprise, I learned that what are called the “mezzanine tranches” of Fannie’s CAS deals—the ones designed to take credit losses above a pre-set percentage absorbed by Fannie, up to another set percentage at which Fannie begins taking losses again—are intentionally structured to avoid taking losses. And Fannie discloses that in its prospectuses.

I never would have guessed this. To help explain its significance, I thought I would begin by giving some basic information about how the CAS structure works.

A typical CAS transaction has three component parts, or tranches. The first is the subordinate tranche, which absorbs a specified initial percentage of credit losses from the pool of mortgages it is protecting until its entire principal is gone. Fannie typically retains this tranche. In all five CAS deals done through the end of 2014, the subordinate tranche was equal to 0.30 percent—or thirty basis points—of the initial principal balance of the pool. That is enough to cover, for example, 1.0 percent defaults with 30 percent loss severity, or 1.2 percent defaults with 25 percent severity. In the four CAS deals issued in 2015, the first loss tranche was somewhat larger, either 0.40 percent or 0.50 percent, with Fannie still retaining all of it. So far this year, however, the subordinate tranche in each of Fannie’s four CAS deals has been 1.0 percent—and Fannie has sold an average of 28 percent of these first-loss tranches to third-party investors, who are being paid an average floating rate of LIBOR plus 11.55 percent to share this risk with Fannie on a pari passu basis.

The pricing on the recent first-loss tranches is quite generous, but the real story is the structuring and attributes of the next two layers—the mezzanine tranches. We’ll use the most recent CAS transaction, priced on July 19, as our example. Its three tranches—one subordinate and two mezzanines—provide what the prospectus calls “initial credit support” (note the word “initial”) of 4.0 percent for a $42.2 billion pool of single-family mortgages. These mortgages all have loan-to-value (LTV) ratios between 60 and 80 percent, with an average LTV of 75.7 percent and an average credit score of 748. The three CAS securities issued against this pool were: (a) $120 million in first-loss “Class 1B Notes,” which share with Fannie in taking all credit losses up to 1.0 percent of the $42.2 billion initial balance of the pool (Fannie’s piece of the 1B tranche, which it retained, was $302 million); (b) $701 million in “Class 1M-2 Notes,” which do not begin taking losses until all of the principal of the Class 1B Notes is exhausted, then take losses up to 2.75 percent of the $42.2 billion initial balance, and (c) $501 million in “Class 1M-1 Notes,” which begin taking losses when the 1M-2 Notes are exhausted, and in theory could take them up to 4.0 percent of the initial pool balance.

One hundred and forty pages into the prospectus for this transaction, there is a section titled “Prepayment and Yield Considerations,” intended to help investors evaluate the risks and potential returns of the notes they are being offered. It includes tables showing losses (called “write-downs”) taken by each of the three CAS tranches under 64 combinations of eight different annual default and prepayment rates. Default rates in the scenarios range from zero percent to 1.0 percent per year, while prepayment rates range from zero to 35 percent per year—a comprehensive span of potential outcomes deemed reasonable by Fannie, its investment bankers and their counsel.

The loss table for the 1M-1 Notes is an eye-opener. For this tranche, which is supposed to absorb losses that exceed 2.75 percent of the pool up to a maximum of 4.0 percent, there is no scenario, out of 64, in which it is shown to take any losses. Lest there be any question, a separate yield table confirms this: buyers of the 1M-1 Notes are shown as receiving the exact same yield—estimated to be 1.95 percent per year—in all 64 scenarios. Fannie is offering investors a “risk-sharing” security that according to its prospectus is risk free.

The sensitivity analysis for the 1M-2 Notes—which absorb losses above 1.0 percent of the pool, up to 2.75 percent—is almost as favorable. That tranche takes losses in only 9 of the 64 scenarios. Four of those have zero prepayments (which is not realistic), while the other five involve cumulative default rates between 4.6 percent and 7.8 percent. The estimated yield on the 1M-2 Notes is 4.79 percent in 55 out of the 64 scenarios, and it is negative (i.e., a net benefit to Fannie) in only three extremely unlikely ones.

My first reaction on seeing these loss and yield tables was disbelief. The mezzanine tranches couldn’t be that good for investors (and that bad for Fannie). But then I reviewed the average life tables in the prospectus, and it immediately became clear what was happening: the 1M-1 and 1M-2 Notes do not remain outstanding long enough to take what should be their share of credit losses.

This is a conscious design feature of the CAS structure. Even with no prepayments in the mortgage pool, the 1M-1 Note amortizes to zero by the end of its life. If there are prepayments—and there will be—after about a year’s worth of initial protection all prepayments associated with the subordinate and two mezzanine tranches are allocated first to the 1M-1 Note, until it is paid off. Next, prepayments are allocated to the 1M-2 Note until it is paid off. Only then do prepayments begin to pay down the subordinate tranche (the 1B Note held by investors, and the much larger 1B piece retained by Fannie). This feature of paying off the risk-bearing CAS tranches in reverse order of their loss-absorbing priority virtually guarantees that the 1M-1 Note will not survive to take losses, and makes it likely that the 1M-2 tranche will be able to provide only a small (or very small) percentage of its “initial” credit support.

As stated above, the July CAS 1M-1 Note does not provide any credit support until after losses exceed 2.75 percent of its associated mortgage pool. Losses of that magnitude take quite some time to develop. Fannie’s 2005 book of business, which had an 8 percent 10-year default rate, took ten years to reach 2.75 percent in losses. And Fannie’s 2006 book of business—which was acquired at the height of the home price bubble, was full of interest-only ARMs and no-doc loans, and had a 10-year default rate of over 13 percent—did not reach a 2.75 percent loss rate until its fifth year. The average life tables in the prospectus reveal that the 1M-1 Note disappears in a little over four years if its mortgage pool prepays at just a 10 percent annual rate, and at a 15 percent pool prepayment rate the 1M-1 Note barely lasts three years. Fannie’s 2005 and 2006 books of business prepaid at annual rates of between 15 and 20 percent. As bad as those two books were, the July 1M-1 CAS “risk-sharing” Note would not have reduced their credit losses by a nickel.

What are we to make of credit risk-sharing securities that take little or no real credit risk? Before addressing this question, I’ll add one more fact: as Fannie’s CAS series has progressed (the July 2016 deal was the thirteenth since October 2013), its successive risk-sharing tranches have provided less, not more, credit protection.

In each of the first five CAS deals through the end of 2014, investors in the Class 1M-2 and 1M-1 Notes were exposed to losses after Fannie absorbed the initial 30 basis points of loss. As a consequence, the sensitivity analyses in the prospectuses for these transactions showed the 1M-2 Note taking losses in 23 scenarios (out of 56—these prospectuses did not show results for the eight scenarios with zero defaults), while the 1M-1 Note took losses in 3 (twice) or 4 scenarios (three times). Fannie’s first-loss risk percentage was raised in the 2015 deals—first to 40, then to 50 basis points—but that did not materially reduce the number of loss-taking scenarios for the 1M-2 Notes (although with Fannie taking the first 50 basis points of loss the 1M-1 Note became loss free). Only by raising Fannie’s first-loss exposure to 100 basis points this year were the architects of the CAS structure able to reduce projected credit losses on the 1M-2 and 1M-l Notes to their current (miniscule) levels.

I think I know what’s going on here. At Treasury’s urging, FHFA has set a goal for Fannie to “transfer credit risk on at least 90 percent of the unpaid principal balance of newly acquired single-family mortgages in loan categories targeted for risk transfer.” Fannie has chosen CAS transactions as the main way to meet that goal. The problem, however, is that there are few if any natural holders of mortgage credit risk in the capital markets. Unlike entities such as Fannie, Freddie or the mortgage insurers, the primary capital markets buyers of Fannie’s CAS Notes—leveraged investors such as hedge funds and commercial banks—cannot count on being able to diversify their mortgage credit risk over time, and most have no independent means of evaluating it. Given these disadvantages, they price each CAS-type transaction to a worst-case outcome to ensure themselves an acceptable return. Fannie’s investment bankers know this, and to continue to sell to this ill-suited and cautious buyer base the large volumes of CAS Notes that Treasury and FHFA insist Fannie issue—at prices that seem reasonable—they’ve ended up creating mezzanine tranches that appear to transfer large amounts of credit risk but in reality transfer almost none.

Wall Street has every incentive to sustain this charade: it has a committed issuer (Fannie), a happy group of 1M-2 Note buyers (who so far this year have gotten securities with little risk, paying an average floating rate of LIBOR plus 550 basis points), and a very happy group of 1M-1 Note buyers (who have gotten securities with no risk, at a floating rate of LIBOR plus 190 basis points). The mystery is why Treasury and FHFA keep pushing what its prospectuses make clear is a Potemkin program. In a previous post (“Risk Sharing or Not”), I speculated that Treasury’s motive was to use CAS deals to try to develop a market for the sorts of risk-sharing securities it hopes can replace Fannie and Freddie as the primary means of financing mortgage credit risk. But that only makes sense if the CAS Notes really do share risk. There is no “market development” benefit from selling risk-sharing notes that transfer no meaningful amount of credit risk to anyone. Is it possible that neither Treasury nor FHFA understand how the 1M-1 and 1M-2 tranches actually work (or rather, don’t work)?

I reviewed the July CAS prospectus for insight into how a dollar of securitized risk coverage could be equated with a dollar of guarantor equity capital. I did indeed gain some insight. Equity capital for a credit guarantor is completely predictable; if you have two dollars of equity, you unequivocally can cover two dollars of credit losses. In contrast, the loss coverage of CAS-type risk-sharing securities is highly uncertain. It depends on the interaction of multiple elements, each of which is unpredictable—the amount and timing of mortgage defaults, the amount of loss severity, and the amount and timing of mortgage prepayments. As we’ve just seen, the July CAS 1M-1 and 1M-2 Notes claim to give coverage for up to three percent of credit losses on the pool of loans they were issued to protect, but at best their actual loss absorption will be a tiny fraction of that. One would be justified in assigning these notes an “equity equivalent” value of zero.

The egregious lack of loss coverage by Fannie’s 2016 CAS risk-bearing tranches can be partially remedied by adding more prepayment protection, keeping the notes outstanding longer so they can absorb more losses. But the broader issue will remain. Credit guarantors must be able to absorb tens of billions of dollars of losses with absolute certainty, and CAS and similar securities do not and never can provide that certainty. This fact, coupled with the revelation from the CAS program that the capacity of capital markets investors to take real, rather than pretended, credit risk is severely limited, should put to rest the notion that securitized risk-sharing ever could be a viable alternative to well capitalized credit guarantors as a source of secondary market financing for the $10 trillion U.S. residential mortgage market.

Finally, then, what should be done with the existing Connecticut Avenue Securities program? Unless Fannie’s investment bankers can radically restructure its 1M-1 and 1M-2 Notes so that they are capable of absorbing some reasonable amount of credit losses, Fannie should stop issuing these securities immediately. They are a sham, and a complete waste of the company’s money.


[Note: The original version of this post stated that the most recent CAS 1M-1 and 1M-2 Notes were issued in August; they in fact were issued in July. This version corrects that error.]

46 thoughts on “Far Less Than Meets the Eye

  1. This is an eye opener, a sort of “The Emperor’s New Clothes.” I’m curious if you’ve gotten any feedback from any CAS/STACR investors? And would be willing to be interviewed for my publication?


    1. I haven’t received any feedback from CAS/STACR investors on this piece (or subsequent ones I’ve done on the same subject), but I’m not surprised about that. I think investors are getting a terrific deal on these–very generous yields with virtually no risk–so they would like Fannie and Freddie to continue to issue them for as long as possible. I’m advocating for an end to the program, because it’s a complete waste of the companies’ money.

      I HAVE received comments from other mortgage security market analysts. So far, none have told me that any of my analysis is in error. Most say some version of “we know these CAS and STACR deals don’t transfer much risk, but we think we can fix that” (I don’t believe that’s possible, for the simple reason that investors don’t want to take mortgage credit risk directly). Others have said they want to look into this themselves, and that if they find I’m right they’ll speak up about them as well. I hope they do.

      And, yes, I’d be willing to be interviewed for your publication. Your e-mail address appears on my “administrative edits” site, so I’ll contact you to give you my own, and we can set something up if you wish.


    1. According to the press release you linked, Fannie Mae has sought and received credit ratings from Fitch Ratings on several of its earlier CAS issuances. In all cases, the ratings are on the more junior of the two mezzanine tranches (called the “M-2” tranche by Fannie), which take losses after the first-loss tranche—typically held by the company—is exhausted. These securities did not carry credit ratings when they first were issued. The press release states, “With these new credit ratings, these CAS notes are eligible to be purchased in the secondary market by funds that require a rating for investment and the notes are now likely to receive more favorable financing terms, further enhancing their liquidity.” I’m sure that’s true.

      I was more interested in the ratings themselves, which ranged from BB+, Fitch’s highest non-investment grade (or “speculative”) rating, to B+, a full grade below and described by Fitch as meaning, “material default risk is present, but a limited margin of safety remains.” This last description seems awfully gloomy for the M-2 structures Fannie describes in its prospectuses, and is even more so given that the securities Fitch has now rated have been outstanding for a while. In the press release, Fannie quotes a managing director of Fitch, Grant Bailey, saying, “”The credit ratings on these notes reflect the strong performance to date of the loans and the structural features that reduce credit risk to investors over time.” My English translation of this statement is, “The loans were of high quality to begin with; they’ve performed very well so far, and the M-2 notes that are supposed to take their credit losses are about to begin paying off [that’s the “structural feature that reduces credit risk over time”] so they’re unlikely to be around to take many losses even if they do come in unexpectedly high.”

      I find it hard to resist a comparison between these ratings and the ratings agencies’ assessments of collateralized debt obligations (CDOs) a decade or so ago. CDOs were composed exclusively of non-investment grade-rated tranches of subprime private-label securities, but all of the credit rating agencies decided they could safely rate 70 to 80 percent of the tranches of a CDO AAA (to quote Fitch again, “assigned only in cases of exceptionally strong capacity for payment of financial commitments.”) We know how those ended up performing. Now we seem to have something of the reverse: risk-sharing tranches that are highly unlikely to take any meaningful level of loss because they are structured to pay off so quickly, yet Fitch is rating them either “speculative” or “highly speculative.” In my view that’s not an evening out; it’s two mistakes, one in each direction.

      Liked by 1 person

      1. Thanks, your reply opened my eyes to many facts that should have been obvious to me. Investors may require a higher rate of return for these 2nd tier tranches with B ratings, making them a harder sale, more difficult to spin off, despite all of Treasurie’s positive spin. I don’t think any large investment banks will try to repackage any of these risk sharing tranches into some type of new CDOs to achieve a triple A rating… Hopefully, I don’t end up eating my own words.
        I will reread this article again tomorrow, with a better realization of what the M-1, M-2 other terms mean.


  2. If state law is not applicable to reviewing the books and records of Fannie Mae because it is federally chartered then can we get that information through a foia request?


  3. Tim,

    Are you able to comment on the recent filing by FHFA with an attachment that states that the charter for Fannie Mae was revoked in 2004 because of unpaid taxes?

    Were you there when this took place, and if so, could you explain why the taxes weren’t paid and Fannie Mae did lose their charter? It appears to be a big development in the Delaware case.


    1. Lisa: The filing you refer to includes an exhibit that is an attestation from Delaware’s secretary of state who first certifies that “the certificate of incorporation of ‘Federal National Mortgage Association, Inc.’ was received and filed in this office the twenty-first day of August, A.D. 2002” (I was still at Fannie Mae then), then goes on to say, “the aforesaid corporation is no longer in existence and good standing under the laws of the state of Delaware having become inoperative and void the first day of March, A.D. 2004 for non-payment of taxes.”

      There are several odd things about this. First, in 2002 we were not “Federal National Mortgage Association, Inc;” by that time we had legally changed our corporate name to “Fannie Mae.” Second, I don’t know why the real Fannie Mae would have been filing a “certificate of incorporation” in Delaware in 2002– it already was incorporated there. Finally, Fannie Mae’s federal charter exempted it from paying state and local taxes (to any state), so “non-payment of taxes” wouldn’t have been a reason for Delaware to void the certificate of incorporation of the real Fannie Mae in 2004.

      I suspect that when all the facts come out about this attestation it will not be the “big development” in the Delaware case it may now appear to be.

      Liked by 2 people

  4. Mike Stegman:

    “In short, because capital is not a free good, a belt and suspenders approach to ensuring against any future government losses by layering capital requirement upon capital requirement or limiting first-loss risk protection to high-cost common equity can pose serious access and affordability challenges. Such an approach may be tantamount to creating a fully privatized secondary market system and the higher costs and reduced access that come with it. That’s why

    it is critical to conduct more deeply empirical work around capital requirements before lawmakers begin the next round of legislative debates on housing finance reform.”

    IF so the truth will win. Fake experts will lose.

    Liked by 1 person

  5. http://bipartisanpolicy.org/blog/housing-how-much-capital-is-enough/ “Tim Howard, a former CFO of Fannie Mae, favors maintaining the GSEs as shareholder-owned institutions but treating them more like utilities by capping their average annual return at ten percent after-tax. He points out that loans no longer allowed by the Consumer Financial Protection Bureau accounted for roughly half of Fannie’s post-crisis credit losses and, if these loans had been removed from Fannie’s 2008 book of business, the company could have survived the crisis with only about 50 basis points of capital.

    Liked by 2 people

  6. Tim,

    You mention above that you were seeking to compare the relative risk transfer economics between capital markets and insurance executions. This is one of the key questions in the CRT discussions that FHFA is gathering input on now. As you know, MBA has favored moving to incorporate more front-end CRT, as we believe that MIs and lenders willing to hold recourse on their loans are likely to be a more stable source of capital over time, given that this capital is raised to manage mortgage credit risk.

    You might take a look at this recent paper written by authors at MGIC which references analysis by Andy Davidson: http://www.iijournals.com/doi/abs/10.3905/jsf.2016.22.1.056
    It provides a comprehensive framework for comparing capital markets vs. MI CRT.




    1. Mike: I agree that deep-cover mortgage insurance is better than Fannie’s or Freddie’s risk-sharing transactions (which do not present a particularly high hurdle to get over). The more important question is: which produces a lower mortgage rate to the borrower– having their loan guaranteed and financed by an adequately capitalized credit guarantor that takes (and capitalizes for) the credit risk on its own, or having that loan financed by a credit guarantor that uses deep-cover MI to share some of the risk?

      To answer that question objectively, we’d need to be able to compare the capital requirements and risk management practices of both the credit guarantors and the mortgage insurers. Unfortunately, we don’t know what the capital requirements for a stand-alone credit guarantor will be, or on what basis they ultimately will be set. (I believe FHFA could independently develop a true stress-based standard for Fannie and Freddie, but so far it has not been willing to do that.)

      There is, however, strong evidence from the latest Dodd-Frank stress tests conducted on Fannie and Freddie that deep-cover MI may not be better that leaving the risk with the credit guarantor. The Fannie/Freddie Dodd-Frank stress tests are conducted over a nine-quarter period, with their “Severely Adverse scenario” assuming a 25 percent decline in home prices. In the most recent application of this scenario (done using Fannie’s and Freddie’s December 31, 2015 books of business) the companies have projected stress credit losses of $27.0 billion and projected net revenues of $30.2 billion, which means that, on an operating basis, they remain profitable throughout the test. But among the non-cash expenses recorded in that test (which are what push both to need further draws from Treasury), there are two MI-related charges. Fannie notes in its write-up of the stress test that “the counterparty with the largest exposure after applying the counterparty default guidance is presumed to default,” and that “a single-family mortgage insurer is determined to have the largest counterparty exposure, and the loss from default is recorded as expense in Q1 2016, without future recoveries.” Fannie also says that further losses were recorded in the stress test “through the application of FHFA-prescribed haircuts on the remaining single-family mortgage insurers.”

      No specific numbers for these MI-related losses are given by Fannie or FHFA (or Freddie, who also was subjected to the stress test), but the important point is that on an operating basis Fannie and Freddie were able to survive the scenario with a 25 percent drop in home prices, whereas the MIs appear not to have been able to (because in the stress test Fannie is forced to take additional losses, first because of the default of the largest MI, then because of haircuts on the others). This stress scenario information is a useful reminder that it is a mistake to advocate any type of risk-sharing arrangement without closely examining the (quantifiable) consequences that would result from it.

      Liked by 1 person

      1. Clearly. However, you are presenting a false choice here. At present, there is not an option for Fannie and Freddie to retain the risk, given that their capital will go to zero by 2018. We need to work with the limited set of options that we have. And I expect that going forward there will be limited appetite for the GSEs to hold most of the credit risk as they did previously.


        1. Here we simply disagree. Fannie and Freddie’s capital “will go to zero by 2018” because Treasury– which wishes to eliminate the companies– is taking it all in the net worth sweep. That action is being challenged in three dozen lawsuits. I believe Treasury will lose these suits, and when it does, the senior preferred stock will be paid down and Fannie and Freddie will begin retaining capital again.

          And even without capital, Fannie and Freddie can “self-insure” the credit risks they’re now taking. They’re receiving an average of 50 basis points (after payment of the 10 basis point payroll tax fee) on the new business they’re doing, which for the next several years will be more than enough to cover the annual expected credit losses on these loans. When the companies cede risk–whether to MIs or to other risk-sharing partners–they also cede revenue. (And Fannie and Freddie currently are giving up hundreds of millions of dollars a year by paying interest on “risk-sharing” securities for which they have very little chance of ever receiving any benefit.)


  7. Tim, the tables in the prospectus max out at a constant default rate of 1.0%. Do you have any idea what year(s) that would equate to, and what Fannie’s or Freddie’s ultimate losses in those years were? A stated objective of the GSE’s programs is to cap losses in the event of another major downturn in housing. In your post, you state that Fannie’s default rate on its 2005 acquisitions were 8-10% with 2.75% losses. If the yield tables were extrapolated to those levels, would investors take a hit? In my opinion, the fair assessment of these structures is how they would perform in severe scenarios (in line with the program’s goals) and not in benign ones.


    1. You’ve asked some good questions here, to which I’ll try to give answers that hopefully are both comprehensive and understandable.

      In my view, a 1.0 percent constant default rate (CDR) for a pool of loans with a maximum LTV of 80 percent, an average LTV of 75.7 percent and an average credit score of 748 is pretty severe. In this case, though, it doesn’t matter what I think; these are Fannie’s sensitivity tables, and it’s up to them, and their counsel, to put forth ones they believe are realistic for the securities being offered.

      The question of what a 1.0 percent CDR equates to has no one answer, because CDR is a stylized calculation—it assumes a constant default rate on the loans in a pool that remain outstanding at the beginning of each year. For that reason, defaults from a 1.0 percent CDR are heavily dependent on prepayment rates (which going forward are unknowable). Fannie shows this interaction between CDRs and prepayments in its prospectus, in a “credit event sensitivity table.” This table shows a 1.0 percent CDR producing a cumulative 10-year default rate of 10.31 percent with zero prepayments; at a 35 percent annual prepayment rate, a 1.0 percent CDR results in a 2.21 percent cumulative default rate. Switching to the loss tables, in no prepayment scenario does a 1.0 percent CDR cause any loss for the most recent CAS 1M-1 Note. For the 1M-2 Note, it requires a 1.0 percent CDR and 10-year prepayment rate of 15 percent to produce an 11 percent loss of principal; a 5 percent annual prepayment rate (which is unrealistically low) still only causes the 1M-2 Note to lose a little over half its principal.

      Moreover, these tables overstate the losses CAS Note buyers actually would experience, because default rates aren’t constant. Even for a bad book of business, defaults are slow in the initial years, then ramp up, typically starting around the fourth year. As I noted in my piece, the CAS 1M-1 Note in particular is engineered to pay off early, and even the CAS 1M-2 Note will be half gone in five years with a 15 percent annual prepayment rate on the pool of mortgages it’s insuring.

      For these reasons, I think it’s better to use actual historical data to evaluate the CAS 1M-1 and 1M-2 Notes as currently structured. Fannie’s 2005 book of business had a 10-year cumulative default rate of 8.0 percent, and a 10-year average prepayment rate of about 19 percent. If you assume that the average loss severity on defaults for the 2005 book was 30 percent (which is about its average, although the severity percentage would have been lower in the early years and higher in the later ones), credit losses would have hit the 1.0 percent threshold (at which the 1M-2 Note begins taking losses) towards the end of the fifth year. At a 19 percent prepayment rate, however, less than one-third of the 1M-2 Note would have been outstanding, and what remained would have been paying down rapidly. So the 1M-2 Note would have taken perhaps 30 basis points of credit losses from the 2005 book. The IM-1 Note—which at a 19 percent prepayment rate would have disappeared in about 2 ½ years—would not have taken any losses.

      In total, then, Fannie’s 2005 book would have had a credit loss rate of 2.4 percent (8 percent defaults and 30 percent severity). With the CAS Notes I discussed in my post, Fannie would have taken the first 1.0 percent losses in any event, with the CAS Notes theoretically taking all losses over that, up to 4.0 percent. In reality what would have happened is that the CAS 1M-2 Note would have taken about 30 basis points of loss, the 1M-1 none, and 2.1 percent of the total 2.4 percent of losses would have been absorbed by Fannie. That’s very inefficient “risk-sharing,” in my view.

      For Fannie’s 2006 book—which after 10 years will have about 4.0 percent in credit losses—I’ll skip the details and just give the estimated results. Using its actual default curve and average (18 percent) prepayment rate, the CAS 1M-1 Note again would have absorbed no losses. The CAS 1M-2 Note would have taken about 100 basis points of loss, leaving Fannie with 3.0 percent (not the 1.0 percent one might have thought, given that it issued “risk-sharing” securities up to 4.0 percent loss).


  8. Tim,

    Should not courts consider these facts to end conservatorship or replace sham conservatorship with real conservatorship?


    1. Since the conservatorship FHFA has taken numerous actions that are glaringly inconsistent with the statutory duties of a conservator, with agreeing to the Net Worth Sweep being the most obvious. Insisting that Fannie issue “risk sharing” notes at very high interest costs that protect the company from few if any losses is just one more example of this–albeit in my opinion an egregious one.

      Liked by 2 people

  9. Evening Tim,

    Thank you for spending your time educating.

    Have you looked to see what the CAS trade for? Do traders price these like they have credit risk when they actually do not?


    1. I have not seen any aftermarket quotes on CAS securities. That’s not to say they don’t trade, just that if they do either the trading prices aren’t published or they appear somewhere I’m not aware of. We CAN observe, however, how the spreads at pricing for the 1M-1 and 1M-2 CAS Notes have changed over the course of the four issuances done so far this year. For all four issuances, the risk profiles of the two Notes have been the same– i.e., no losses in any of the 64 scenarios for the 1M-1 Notes, and losses in (the same) 9 of 64 scenarios for the 1M-2 Notes. Spreads to LIBOR on the most recent issuances of these securities were notably lower than earlier this year. The latest 1M-1 issue was sold at a spread of LIBOR plus 145 points, down from a pricing spread of LIBOR plus 215 basis points in March, while the latest 1M-2 issue was sold at a spread of LIBOR plus 475 basis points, down from a spread of LIBOR plus 675 basis points in February. So it does appear as if investors have noticed how little credit risk these notes actually carry.


  10. So, basically, you are saying that government officials have stood up before Congress and said, “We are creating risk sharing products that bring more private money into the mortgage system and reduce the role of Fannie and Freddie etc., etc.” However, reading the fine print, no such risk sharing is really happening in fact. These government officials are lying and hoping that the sheer complexity of the documents is enough to throw Congress off the scent.

    If this is true, what would motivate this deception?


    1. I don’t know who has been saying what, specifically, about Fannie’s risk-sharing deals. But the prospectuses for them make clear that little of any risk sharing will actually take place. For me the mystery is: who at Treasury, FHFA and Fannie know that these deals don’t do what they are touted as doing, and which people simply don’t know–or don’t understand them–and are assuming that the deals really will accomplish meaningful risk sharing because “everybody” says they will. I suspect that more than a few people at one or more of the agencies DO understand the deals, and the question for me is: why are they continuing to insist that Fannie keep doing them? And on that issue, I wish I knew, but I don’t.

      Liked by 2 people

      1. Probably something like this happened:

        1. FHFA/Treasury had the idea of creating CAS and drafted the outline of the securities.
        2. FHFA/Treasury reps started talking with counter-parties and received feedback.
        3. FHFA/Treasury reps learned that counter-parties were uninterested in deal’s terms and went back to bosses with revisions that removed all risk to counter-parties.
        4. FHFA/Treasury politicals instructed reps to execute the give-aways so that they could report to political leaders that they had “achieved” risk-sharing.
        5. All players assumed that the deals were so complex that no one would notice.
        6. Reps can complain they were “ordered” to do the deal and politicals can claim they are not specialists and do not “understand” the deals.
        7. Counter-parties get free money.

        This is corruption. This is how it works. But who is going to investigate? Not DOJ. Not Congress.


      2. Besides the government being filled with GSE dumbos, next you’re going to tell us, ‘There’s gambling at Rick’s’ “


  11. I hope you realize that you alone stand in the way of Treasury’s efforts to decimate F&F by any means possible. Very few people understand the technical aspects of what you wrote (me included) and that is what they are counting on. If you could, please forward this to the plaintiffs attorneys. I am so thankful we have someone like you that can analyze their shenanigans and expose it to daylight.

    Liked by 3 people

  12. Part of my email to Peter Roff writing in U.S. News & World Reports today August 8th 2016. Link to his article on GSElinks today.
    http://www.howardonmortgagefinance.com – I challenge you to write an article stating Mr. Howard is not correct or the foremost expert on the subjects of your article, Fannie and Freddie and Mortgage Finance past, present or future. I dare you.
    Hope you don’t mind Mr. Howard. I attempt to digest as much as the technical as possible was well. I must be making progress because I do understand more than I did before your first article in January 2015 and this blog since. Facts, numbers, names, dates for all to dispute. I have yet to see anyone present a denial of your statements or technical offerings.

    Thank you again for helping me to better understand my investment in FNMA and FMCC. Thank you for your book The Mortgage Wars, the greatest source of the “big picture” and how there is so much more to this matter than most people know. I look forward to your posts knowing I am getting no B.S. facts that none can dispute with any credibility.

    Liked by 3 people

  13. This may be a stupid game which Fannie has to play. Fannie can tell the world that the absolute max risk it bears is, say, 1%. So if California has statewide earth quake, other parties are responsible for everything beyond 1% loss.


  14. I agree with this.

    “The tax section of the bond documents suggest there isn’t much risk of bondholders not getting paid. The companies both expect that payments under the bonds will be favorably treated as “qualified stated interest” payments, because the likelihood of reductions in amounts owed to investors is so “remote” that they can be considered unconditional payment promises.”


  15. Way over my head Mr. Howard but it sounds so not conserving and typical government, and why most things are best not run by the government. Especially when people at the top are more in tune to protect their interest rather than the long term interests of the stakeholders or even the country!
    Thank you for your time on this analysis!


    1. This definitely was one of my more technical posts, but I felt it needed to be since I am making some serious criticisms of Fannie Mae’s risk-sharing securities issuance program and felt I need to back those criticisms up with factual evidence and analysis.

      For a generalist reader, the main “takeaway” from the post is that Fannie’s Connecticut Avenue Securities (CAS) risk-sharing securities are structured in a way that will transfer very few credit losses from Fannie Mae to the “private capital” holders of CAS securities, even if credit losses are unexpectedly high. This will come as a surprise to most people (it was a surprise to me), but it’s not an accident. The risk-bearing securities in CAS transactions are intentionally structured so that they will pay off before–and in some cases long before– the credit losses they are supposed be absorbing take place.

      Fannie is being required to issue CAS securities by FHFA (which I believe is acting at the direction of Treasury). It is concerning, at the very least, that Fannie’s “conservator,” FHFA, would be requiring the company to issue large volumes of risk-sharing securities, at high rates of interest, that in fact will provide very little benefit even if credit losses spike. By shining a spotlight on this issue, I am hoping that FHFA (and Treasury) will be pressured into either changing the structure of Fannie’s CAS securities so that they DO provide some benefit to the company, or allow Fannie to stop issuing them altogether.

      Liked by 6 people

      1. I’m going to read this several more times but I think I got the idea. I like this technical stuff.

        Are these the same securities Treasury have been buying for their portfolio or is it just my imagination?


        1. I don’t believe Treasury has purchased or holds any agency securities of any type. The Federal Reserve does now hold $855 billion of Fannie’s mortgage-backed securities in its portfolio– up from zero at the time of the financial crisis– but according to New York Fed data it doesn’t own any of Fannie’s CAS securities.

          And good for you for sticking with the “technical stuff.” In writing these pieces I’m attempting to get some important facts injected into the mortgage reform debate (and, indirectly, into the legal cases), and doing that successfully unfortunately requires some arcane detail that, for those not immersed in the subject matter, isn’t easily digested on the first one or two readings. But it’s all in a good cause.


          1. Thank you for the clarification on my question. I also hope the legal teams review your “technical stuff”. Keep up the great analysis. We all greatly appreciate it!

            Liked by 2 people

      2. great work as usual tim. this sure doesnt make one confident that all of the urban institute proposals premised on private capital replacing GSEs make any sense!


      3. Thank you Mr. Howard for your response! I understand better now! Should we expect any less from this Admin! I say that sarcastically! Perfect example why the future system needs to not have any government influence at all other then oversight. They are always using the GSE to wins elections which is part of the problem!


      4. This should be added to the Washington federal complaint. Unfortunately you have to give them guys some credit, they said they were “going to stab this thing through the heart and salt the Earth so I never grew back” and they are damn sure trying.


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