How Fannie Mae and Freddie Mac Share Credit Risk With Other Entities

1. Congressional Budget Office How Fannie Mae and Freddie Mac Share Credit Risk With Other Entities October 6, 2017 Sebastien Gay Assistant Director, Financial Analysis Division 2017 Real Estate Research Symposium Kenan-Flagler Business School The University of North Carolina at Chapel Hill

2. 1CONGRESSIONAL BUDGET OFFICE Activities of Fannie Mae and Freddie Mac (the GSEs)

3. 2CONGRESSIONAL BUDGET OFFICE Mortgage Debt Outstanding, 2000 to 2016 2 4 6 8 10 12 14 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 Multifamily Single-Family Trillions of Dollars

4. 3CONGRESSIONAL BUDGET OFFICE Multifamily Mortgage Debt Outstanding, by Holder, End of 2016 Financial Institution 41% Federal and Related Agency 24% Mortgage Pool or Trust 25% Individuals & Others 10%

5. 4CONGRESSIONAL BUDGET OFFICE Single-Family Mortgage Debt Outstanding, by Holder, End of 2016 Financial Institution 25% Federal and Related Agency 45% Mortgage Pool or Trust 22% Individuals & Others 8%

6. 5CONGRESSIONAL BUDGET OFFICE What the GSEs Do ■ Multifamily ■ Single-Family ■ Portfolio

7. 6CONGRESSIONAL BUDGET OFFICE Guarantees and Securitization of Multifamily Loans, End of 2016 Fannie Mae ■ Multifamily guaranteed principal: $243 billion ■ Average loan size:1 $15 million ■ Delinquency rate: 0.05 percent Freddie Mac ■ Multifamily guaranteed principal: $158 billion ■ Average loan size:2 $18 million ■ Delinquency rate: 0.03 percent Notes 1. Based on Delegated Underwriting and Servicing large-balance loans only. 2. Based on K-Deals only.

8. 7CONGRESSIONAL BUDGET OFFICE Guarantees and Securitization of Single-Family Loans, End of 2016 Fannie Mae ■ Single-family guaranteed principal:1 $2,800 billion ■ Average loan size:1 $163,200 ■ Delinquency rate: 1.20 percent Freddie Mac ■ Single-family guaranteed principal: $1,755 billion ■ Average loan size: $165,500 ■ Delinquency rate: 1.00 percent Note 1. Represents unpaid principal balance.

9. 8CONGRESSIONAL BUDGET OFFICE GSE Delinquency Rates, Pre- and Post-Crisis 0 1 2 3 4 5 6 1999 2001 2003 2005 2007 2009 2011 2013 2015 Percent Single-Family Multifamily Fannie Mae Freddie Mac Source: Fannie Mae and Freddie Mac Monthly Volume Summaries (Single-Family 90- Plus Day Delinquency Rate and Multifamily 60-Plus Day Delinquency Rate). 5.59% 4.2% 0.8% 0.4%

10. 9CONGRESSIONAL BUDGET OFFICE Portfolio Operations ■ Invest in mortgage-related assets ■ Assume interest rate risk, credit risk, liquidity risk ■ Provide support for single-family and multifamily guarantee businesses

11. 10CONGRESSIONAL BUDGET OFFICE The GSEs’ History of Sharing Credit Risk ■ Multifamily loans since 1988 ■ Single-family loans since 2013

12. 11CONGRESSIONAL BUDGET OFFICE Goals of Sharing Credit Risk ■ Reduce the risk to taxpayers from future losses associated with credit guarantees ■ Create a broader, more liquid marketplace for mortgage credit risk ■ Make the price of credit risk for mortgages transparent

13. 12CONGRESSIONAL BUDGET OFFICE Sharing Credit Risk on Multifamily Loans

14. 13CONGRESSIONAL BUDGET OFFICE Fannie Mae’s Delegated Underwriting and Servicing (DUS) Program ■ Lenders underwrite and service loans using Fannie Mae’s criteria ■ Fannie Mae purchases the loans without additional underwriting ■ Lenders agree to bear a portion of the credit risk on those loans – Prorated basis (such as one-third of all losses) – Tiered basis (such as the first 5 percentage points of losses)

15. 14CONGRESSIONAL BUDGET OFFICE Freddie Mac’s K-Deals ■ Freddie Mac transfers loans to a third-party trust ■ The trust issues three classes of bonds—senior, mezzanine, and subordinated—backed by those loans ■ Freddie Mac purchases the senior bonds – Produces securities known as K-Series Multifamily Mortgage Pass- Through Certificates – Sells them to investors with its own guarantee against future credit losses

16. 15CONGRESSIONAL BUDGET OFFICE Freddie Mac’s K-Deals, Continued ■ The third-party trust sells the subordinated bonds to investors without Freddie Mac’s guarantee ■ Any losses from defaults are allocated first to investors who do not hold the senior bonds ■ Remaining losses are allocated to Freddie Mac ■ Holders of the senior bonds bear no credit risk

17. 16CONGRESSIONAL BUDGET OFFICE Facts About Credit Risk Transfers for Multifamily Loans Fannie Mae ■ Total multifamily losses recognized in 2016: $32 million ■ Fannie Mae’s share of 2016 losses: $23 million ■ Lender’s share of 2016 losses: $9 million ■ From 2006 to 2016, lenders have assumed about 30 percent of all multifamily losses Freddie Mac1 ■ New issued in 2016: 61 ■ Guaranteed securities issued in 2016: $43.8 billion ■ Unguaranteed securities issued in 2016: $6.1 billion Note 1. Includes K-Deals and SB Certificates (securities backed by small balance multifamily loans).

18. 17CONGRESSIONAL BUDGET OFFICE Sharing Credit Risk on Single-Family Loans

19. 18CONGRESSIONAL BUDGET OFFICE How Risk Is Shared on Single-Family Loans ■ The GSEs use largely the same structures to share risk in the single-family market ■ Credit risk notes account for about four-fifths of risk sharing

20. 19CONGRESSIONAL BUDGET OFFICE How Credit Risk Notes Work

21. 20CONGRESSIONAL BUDGET OFFICE How Credit Risk Notes Work, Continued ■ The performance of credit risk notes are tied to an underlying pool of loans, called a reference pool ■ The principal balance of the credit risk notes is a percentage of the total principal balance of the reference pool ■ The GSEs pay interest on the principal balance of the credit risk notes

22. 21CONGRESSIONAL BUDGET OFFICE More About How Credit Risk Notes Work ■ Principal payments on reference loans – Repay the most senior notes first – Are prorated: If the notes represent 1 percent of the reference pool, 1 percent of principal payments are applied to repay the credit risk note investors ■ Losses on reference loans – Reduce the balance of the most subordinate note outstanding – Are fully applied to the notes: $1 of losses on the reference loans reduces the principal balance of the credit risk notes by $1

23. 22CONGRESSIONAL BUDGET OFFICE Other Ways Risk Is Shared on Single-Family Loans ■ About one-fifth of risk sharing uses other forms of transactions – Senior bonds shielded from credit losses by subordinate bonds – Supplementary insurance to cover losses on a pool of loans that exceed coverage provided by primary loan-level mortgage insurance – Arrangements whereby the lender retains a portion of the credit risk

24. 23CONGRESSIONAL BUDGET OFFICE Facts About Credit Risk Transfers for Single-Family Loans Fannie Mae1 ■ Reference pool of 2016 transactions: $315.2 billion ■ Credit risk retained in 2016 transactions: $306.0 billion ■ Credit risk transferred in 2016 transactions: $9.2 billion Freddie Mac2 ■ Reference pool of 2016 transactions: $210.1 billion ■ Credit risk retained in 2016 transactions: $201.8 billion ■ Credit risk transferred in 2016 transactions: $8.1 billion Notes 1. Includes Connecticut Avenue Securities and Credit Insurance Risk Transfer transactions. 2. Includes Structured Agency Credit Risk and Agency Credit Insurance Structure transactions.

25. 24CONGRESSIONAL BUDGET OFFICE Lenders’ Roles and Responsibilities in Sharing Risk

26. 25CONGRESSIONAL BUDGET OFFICE Lenders and Multifamily Loans Fannie Mae’s DUS ■ Lenders are preapproved to underwrite and service loans by Fannie Mae ■ In exchange, lenders bear a portion of the credit risk Freddie Mac’s K-Deals ■ Freddie Mac fully underwrites loans ■ Lenders are not responsible for losses ■ Risk sharing is created through the securitization process, with Freddie Mac issuing unguaranteed securities for a portion of the loans acquired

27. 26CONGRESSIONAL BUDGET OFFICE Lenders and Single-Family Loans Credit risk notes ■ Lenders are not responsible for losses ■ Risk sharing is created through the securitization process Lender risk retention ■ In exchange for compensation, lenders bear a portion of the credit risk Supplementary insurance ■ Lenders are not responsible for losses ■ Risk sharing is created through insurance contracts

28. 27CONGRESSIONAL BUDGET OFFICE Counterparty Risk Issues With Credit Risk Transfer (CRT) ■ Counterparty risk is the possibility that CRT investors will not reimburse the GSEs for their contractual share of future losses ■ Risk shared through securitization (K-deals and credit risk notes) limits GSEs’ counterparty risk ■ Risk shared through DUS, reinsurance, and lender risk retention exposes the GSEs to counterparty risk if the lenders or insurers fail

29. 28CONGRESSIONAL BUDGET OFFICE The Impact of Risk-Sharing Transactions

30. 29CONGRESSIONAL BUDGET OFFICE Budgetary Effect of the GSEs ■ GSEs’ single-family and multifamily activities are estimated on a fair-value basis in CBO’s budget projections ■ Fair-value subsidy cost can be interpreted as the competitive market price that an investor would charge to take on the government’s mortgage guarantees ■ Fair-value cost includes the cost of market risk, or what remains after a portfolio has been diversified as much as possible

31. 30CONGRESSIONAL BUDGET OFFICE Budgetary Effect of Credit Risk Sharing ■ Single-family and multifamily risk-sharing programs have no net budgetary cost on a fair-value basis ■ Transfers are executed in a fully functioning liquid market, and the GSEs use a competitive process to determine the price they will pay ■ Every dollar of fair-value cost transferred to risk-sharing partners is offset by a dollar of fair-value revenue paid to those partners to accept that risk

32. 31CONGRESSIONAL BUDGET OFFICE Other Measures of Credit Risk Sharing Risk Exposure ■ Defined as the insurance (or guarantee) loss component of the fair-value subsidy estimate Net Annual Premiums ■ Defined as guarantee fee income net of interest paid to credit risk transfer investors and losses borne by the GSEs in excess of losses borne by credit risk transfer investors

33. 32CONGRESSIONAL BUDGET OFFICE Risk Exposure ■ Credit risk transfer will shift relatively small amounts of risk to private investors in normal economic times ■ Transfers will become more significant during a financial crisis, housing crisis, or both

34. 33CONGRESSIONAL BUDGET OFFICE Net Annual Premium ■ Credit risk transfers may increase the likelihood that the GSEs will need to make a small draw on the Treasury – Interest paid to CRT investors exceeds the value of losses borne by those investors, resulting in lower net income for the GSEs in each quarter ■ Transfers would reduce the amount the GSEs would need to draw in adverse economic conditions – Large GSE losses during a large or sustained economic downturn would be buffered by the risk borne by private investors

35. 34CONGRESSIONAL BUDGET OFFICE References ■ Federal Reserve Board, “Mortgage Debt Outstanding,” https://www.federalreserve.gov/data/mortoutstand/current.htm ■ Fannie Mae, “Monthly Summary,” http://www.fanniemae.com/portal/about- fm/investor-relations/monthly-summary.html ■ Fannie Mae, “2016 Annual Report on Form 10-K,” http://www.fanniemae.com/portal/about-fm/investor-relations/annual-reports-proxy- statements.html ■ Fannie Mae, “2016 Credit Supplement,” http://www.fanniemae.com/portal/about- fm/investor-relations/quarterly-annual-results.html ■ Freddie Mac, “Monthly Volume Summaries,” http://www.freddiemac.com/investors/financials/monthly-volume-summaries.html ■ Freddie Mac, “2016 Annual Report on Form 10-K,” http://www.freddiemac.com/investors/financials/annual-reports.html

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