When it comes to mortgage credit risk, many policymakers today are searching for ways to shield the federal government from all risks short of a major economic catastrophe. They want to build a future system where private capital bears the risk of most residential mortgages, and have a federal backstop only in cases of emergency.
One set of experiences that can be informative to this discussion is the way Freddie Mac Multifamily securitizes mortgages for apartment loans, the vast majority of which support affordable rental housing.
Our program is called K-Deals, and it is how we finance almost all our loan purchases. Here is how it works. When we purchase loans, we assemble them into diversified pools, and place them into securities that are comprised of two classes of bonds: guaranteed senior bonds and unguaranteed bonds known as subordinate and mezzanine bonds. Should credit losses materialize, those losses are initially borne by the private investors who have purchased the subordinate bond. That is called a “first-loss position” or a “B-piece,” and in our K-Deals, it typically represents the first 7.5 percent of the mortgage pool. In the unlikely event that losses were to exceed this level, losses would then be absorbed by yet a second layer, the mezzanine bonds, which represent another 5 to 10 percent of the mortgage pool.
On average, these unguaranteed bonds represent approximately 15 percent of the mortgage pool, which would likely be sufficient to absorb all the losses in the pool if even half of all the loans were to default.* These two classes of unguaranteed bonds act like a succession of fire walls: only after losses in the total pool (and not loan by loan) exceed the total amount of subordination in each of the unguaranteed classes would Freddie Mac be exposed to a single dollar of credit loss. Given that our current loan delinquency rate is just 0.06 percent and our loss rate is a microscopic 0.01 percent, 15 percent is a very big level of protection. Thus, the senior bonds we guarantee, where the risk is borne by taxpayers, have so little risk exposure that they, in effect, function more like catastrophic insurance for investors.
Freddie Mac Multifamily is the only government-backed entity that has such a financing structure. And it has worked well. To date, K-Deals have financed $60 billion in apartment loans and the current delinquency rate on these deals is as low as it can possibly be: zero.
The quality of loan underwriting has been a key part of our K-Deal success. Every three weeks or so, we issue a new K-Deal which contains about 80 underlying loans that have been underwritten, structured and priced by in-house staff. When we do this, there are lots of eyes on us: a subordinate bond investor, multiple mezzanine investors and a dozen or more investors in senior bonds.
Also looking closely at us are rating agencies (typically two firms render independent opinions on each K-Deal), master and special loan servicers, trustees and Wall Street research analysts.
Together, all these parties probe our credit standards, asset quality and program changes. Their collective attention and feedback instills within us market discipline and accountability, forcing us to continuously improve our securities program such that we can continue to finance affordable rental housing.
Of course, we were not always in this position. As recently as 2008, we had financed 98 percent of multifamily loan purchases through Freddie Mac’s retained portfolio. When the company entered conservatorship, the risk was fully borne by taxpayers. K-Deals and other forms of securitization supported the remaining 2 percent. It took just four years to completely reverse these figures, a testament to our ability to innovate, learn from the capital markets and implement a completely new business model.
*Based on the assumption that average loss severity or loss given default is approximately 28.7 percent, which has been Freddie Mac Multifamily’s historical average loss severity over the past 20 years.
This commentary is excerpted from mortgage finance giant Freddie Mac’s Executive Perspectives Blog. David Brickman is senior vice president for Freddie Mac’s multifamily finance unit.