A Model for the Future of Mortgage Securitization

source: Freddie Mac

Multifamily SVP David Brickman
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 five 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 firewalls: 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 U.S. 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.

Indeed, the delinquency rates on our entire portfolio have been consistently low, going no higher than 0.26 percent during the height of the U.S. financial crisis, compared to more than 11 percent for privately-funded commercial backed mortgage securities (CMBS). And so far this year, we have experienced just $3 million in net credit losses on a $130 billion loan portfolio. [SEE GSE CRITICS IGNORE LOAN PERFORMANCE]

Indeed, 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.

Our investor base is broad. It includes conventional real estate investors who may view our subordinate bonds like other real estate equity investments; life insurance companies and pension fund managers seeking high yield on our mezzanine bonds; and major financial institutions that treat our senior bonds as an alternative to Treasury 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 U.S. taxpayers. K-Deals and other forms of securitization supported the remaining two 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.

But we did not merely replicate a securitization model in which we shouldered most of the credit risk. Instead, we looked for ways to marry two things: a CMBS-like structure where we could lay off significant amounts of risk, and features commonly found in portfolio lending that provided a certain amount of flexibility to borrowers. We also had to transform the infrastructure within our business, from accounting, information systems, legal documentation, and more. Then, in June 2009, we issued our first modern K certificate. More than 50 have followed.

Our efforts during this time have financed more than two million apartment units, shielded taxpayers from most credit risk, and built a durable business model that has contributed about $5 billion in net segment earnings to Freddie Mac. We have worked to avoid relying merely on the special powers and privileges of being a government-sponsored enterprise, and instead establish best practices in mortgage securitization, credit standards, and asset management. To this end, any one K-Deal is more than the sum of its individual loans; instead, it is a Freddie Mac Multifamily deal, with the earned power of its brand behind it.

In 2013, we find our business as one that has shed its past as a “buy and hold” investor that, when Freddie Mac entered conservatorship, placed U.S. taxpayers in a first-loss position. Now we are a true financial intermediary that is less of a risk taker and more of a market maker and liquidity provider in all economic cycles.

In recent years, rental housing has been a growing part of the U.S. economy, for those who rent for economic need and lifestyle choice. At Freddie Mac Multifamily, our K-Deal securities program has proven to be an effective means to finance housing for this ever-growing population while exposing taxpayers to minimal risk. By its program structure, K-Deals offer one proof point that mortgage securitization, if done right, can attract substantial private investment while assuring market support for affordable rental housing.

*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

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