Why Are Fannie, Freddie Peddling Exotic Junk-Rated Risk Swaps?
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As mortgage giants Fannie and Freddie bend the knee to their political overlords, they securitize ever riskier loans. It’s a sign of the times.
But while no one was looking, the twins – who wield the full faith and credit of the U.S. government – began quietly offloading this surplus risk in the form of so-called “credit-risk transfers.” The U.S. taxpayer should be worried. As the public learned in 2008 with AIG’s credit-default swaps, hidden risk injected into the financial system doesn’t stay hidden for long.
The twins, in federal conservatorship since the financial crisis of 2007-2008, have become redoubts of wokeness, and this has affected mortgage underwriting practices. Like relatives of a manipulative meth user, the nation’s real property appraisers can only watch developments with alarm.
To offset the new risks within their residential mortgage pools, the twins are offloading the froth in the form of the aforementioned junk-rated credit-risk transfers. The product line was quietly created during the first term of the Obama administration. The product resembles the credit-default swaps that required massive federal intervention with AIG, then the world’s largest insurer. The U.S. taxpayer was dunned for a $68 billion bailout to avoid a global prairie fire. It was the third-largest bailout of the financial crisis, right behind the $72 billion given to Freddie and the $120 billion provided to Fannie.
The new junk product comes as no surprise. The twin gorgons have been a constant source of such mischief. The systemic risk the twins represent will never go away so long as there are politicians who believe they can exploit the duo for political gain.
The credit-risk transfers – known to investors as “CRTs” – create a Dr. Jekyll-Mr. Hyde approach at the twins as they compartmentalize their dark side. Unlike Freddie and Fannie’s mortgage-backed securities, which guarantee investors their principal and interest, the credit-risk transfers guarantee nothing. They merely reference a group of loans, making the junk investments a form of synthetic security. It smacks of the synthetic instruments that were all the rage in the lead-up to the financial crisis.
Under the banner of reducing taxpayer risk, Fannie and Freddie now partner with private capital to peddle the swaps and help keep the niche market liquid. If it ever goes illiquid, watch out. It could set off a new contagion, the only serum for which will be new taxpayer bailouts.
The nation’s 80,000 real property appraisers have had a front-row seat to the surplus risk being shouldered by Freddie and Fannie on the front end. Wherever the twins tread, their allies – the homebuilders, Realtors, chartered banks, fintechs and nonbank lenders – are never far away.
While Fannie and Freddie began pioneering these get-out-of-jail-free cards for back-end risk, they began piling on risk on the front end by allowing abridged appraisals of collateral in the mortgages they securitize, publicizing use of appraiser blacklists to intimidate potentially heretical appraisers, encouraging appraisal waivers, relying on so-called black-box appraisals – appraisals done by Zestimate-like algorithms – tinkering with higher thresholds for when an appraisal is required and keeping appraisers from physically inspecting the properties they appraise – so-called “hybrid appraisals.”
Lately, Fannie has been sending unsigned computer-generated loan buy-back demands to mortgage originators and appraisers in Hail Mary attempts to get out from under early Covid-era loans it was politically pressured to backstop.
Meanwhile, cratering home prices are eroding demand for the junk-rated credit transfers. That’s not good. Spooked investors are unloading the securities, worried about defaults if rising interest rates result in a deep recession.
“Credit risk transfer is not a panacea for Fannie and Freddie,” wrote Landon D. Parsons and Michael Shemi in The Journal of Structured Finance. “[The swaps] are not a replacement for stable and permanent equity capital that supports expected risk.”
The Federal Housing Finance Agency – Freddie and Fannie’s politicized federal regulator – was critical of the program in a 2021 report. The regulator wrote: “Concerns have been raised that [credit-risk transfer] markets may be easily disrupted during periods of market stress, requiring the Enterprises to retain credit risk they had planned to transfer. The experience during and after the COVID-19 stress offers some support to these concerns. [Credit risk transfers] remain untested by a serious credit event.”
Bottom line: Fannie and Freddie have outsourced default risk to private investors. In exchange for a premium, these private investors – asset managers, pensions and hedge funds – issue a pledge to pay in the event of failure. A roughly $60 billion niche market few have heard about acts as an insurance clearinghouse for the two agencies on the risky slices of its roughly $4.5 trillion of mortgages.
But because of the lack of insurance protocols, there are no assurances these investors will be able to pay should the mortgages fail. In that regard, the credit-risk transfers are much like the credit-default swaps AIG bought with abandon.
“The credit-risk transfers constitute an undefined financial risk,” wrote Milton Ezrati in Forbes in November. “No one can assess whether those masking the assurances can pay, and so no one can tell where failure might spread.”
Fannie and Freddie have clearly looked into the abyss and found it looking back at them. But unlike private-label creators of junk insurance policies, Fannie and Freddie always have the U.S. taxpayer as the deep pocket of last resort.