Two Cheers for Fannie and Freddie Synthetic CDOs

My ears perk up whenever I hear the musical words "synthetic collateralized debt offering". (Bill Bratton and I did write the paper on history of these crazy things, after all....) So, it was with interest that I read a Wall Street Journal editorial decrying Fannie Mae and Freddie Mac's use of synthetic CDOs to transfer credit risk on mortgages to the private market through the STACR and Connecticut Avenue programs. Unfortunately, the WSJ piece does not accurately describe what Fannie and Freddie are doing and fails entirely to understand why unfiltered private capital is a recipe for financial instability in housing markets. 

To review, a synthetic CDO is a securitization of a set of credit default swaps (CDS). The CDO entity sells a bunch of CDS protection on some assets, in this case Fannie and Freddie mortgages or MBS. Fannie and Freddie make periodic protection payments (insurance premia) until and unless there is a default under the CDS, in which case the CDO pays Fannie and Freddie.  The CDO gets the money to pay Fannie and Freddie by selling structured (that is senior-subordinate tranched) securities, the proceeds of which it invests in very safe Treasury securities.  So the credit risk on the mortgages or MBS is transferred synthetically to the investors' in the CDO securities without the mortgages or MBS ever leaving Fannie and Freddie's books.

As it happens, only a small slice of the synthetic CDOs are being offered to investors--some of the mezzanine tranches.  The notional senior and junior tranches are not being sold. What this means is that the WSJ's claim that the GSEs are using synthetic CDOs for $800 billion of their $4 trillion book of business is incredibly misleading. The notional amount of the mortgages covered by the CDOs might be $800 billion, but private capital is backing only about $25 billion ($12.7B in STACR deals and $12B in Connecticut Avenue deals). The private capital in the synthetic CDO deals accounts for less than 0.625% of the credit risk held by the GSEs. In other words, this isn't that big of a deal, at least yet. 

Still, synthetic CDOs have a long association with financial scandal, from Michael Milken to Enron to Abacus. That's enough to make one immediately suspicious. But synthetic CDOs aren't an inherently bad product. The problem is that they have often been used as a vehicle for regulatory capital arbitrage. Is there something to worry about here? 

I don't immediately see a problem. It's not clear to me how, if at all, these synthetic CDOs are counted against the GSE's regulatory capital requirements, but at this point, they aren't big enough to worry about. (What we should worry about is what would happen if there's another housing downturn as the Fed can't drop interest rates any meaningful amount, and the GSEs' capital lifeline from Treasury might not be bottomless.)

In fact, I think the synthetic CDOs are probably a very good development for the GSEs. The fundamental policy tension in housing finance is between the relative problems and benefits of public and private capital, neither of which is ideal.  There are obvious problems with public provision of housing finance--it can easily become politicized and result in the public incurring underpriced risk. This was a problem in the run-up to 2008, even if it did not (sorry WSJ) cause the financial crisis. (Note the irony that the WSJ wants to tar the GSEs with the evil buzzword of synthetic CDOs, which previously were only a private-market phenomenon.) The problems in GSE underwriting were far surpassed by those in the private-label market, and losses on GSE loans never came anywhere close to those on private-label securitized loans. But we did have a real political economy problem with the GSEs. 

Private provision of housing finance is also problematic, and perhaps more so. Private capital markets aren't capable of providing anything more than a fraction of the capital needed for US housing markets without causing a wholesale collapse in housing prices--there just isn't the appetite for $10 trillion in credit risk at anything close to current mortgage rates. Moreover, private capital is likely to result in much less stable housing finance markets.  

Private capital markets want risk-based pricing of mortgages. While we generally think risk-based pricing is a good thing, it isn't in housing finance markets because a major risk factor is location, and there is significant geospatial and serial correlation of housing prices. The price of my house is linked to those of nearby houses. This is a unique feature of housing (and real estate) as an asset class. The result is that if my neighbor is riskier (by whatever measure), it will affect my home price, and vice-versa. (The intermediate assumption here is that most homes are purchased on credit and the availability of credit will therefore affect home prices.)

Risk-based mortgage capital will mean tremendous geographic disparities in capital availability. That was the situation in the private, pre-GSE housing market, as there was much less capital available in the South and West. (We'll end up with effective red-lining too, with no capital in poor neighborhoods.) 

Risk-based mortgage capital also means much more susceptibility to local bubbles and booms. Illinois has budget woes? Watch Illinois housing prices fall (which will in turn further exacerbate budget problems, etc.). The same is true on the way up. We will get self-reinforcing local booms and busts.  That's a real problem given how much of household savings are tied up in housing as an asset class, and how much our state and local tax base (and thus government services) depends on real estate taxes.

Private mortgage capital is a recipe for financial instability, as is public mortgage capital. The challenge we face in housing finance is how to yoke together the best aspects of both without the downsides of either. Serious thinking about housing finance needs to address this without being shaped by ideological priors that favor either private or public capital. We are already living in a hybrid world (private markets bear interest rate risk, not credit risk for the GSEs), and any future housing finance system is going to be some sort of a hybrid.  

The synthetic CDOs present a potential (and I emphasize potential) way of bringing in the benefits of private capital without the downsides. The synthetic CDO can essentially act as a filter against too-much risk-based pricing. Let's assume (and this detail isn't clear to me) that the synthetic CDOs are based on a blended bunch of GSE-held mortgages, without geographic information being made available to investors (I believe this is the case, but am not 100% sure). If so, there would not be geographically-risk-based pricing of the CDOs, and we'd get some of the benefits of private capital--namely lack of public assumption of risk, without the downside financial market instability. Yes, we'd lose some of the market discipline that comes with private capital, but the part we'd lose would be the part we don't really want to have. There's a limit to the synthetic CDOs--I don't think they will ever handle the majority of the GSEs' credit risk, but they're a step forward. So a tentative two cheers for Fannie and Freddie CDOs. 

Update:  Only one cheer for the Fannie/Freddie CDOs. It turns out that they are releasing some geographic information about the loan pools:  state and (if I'm reading correctly) MSA-level data. That's not good. The pools are blended, however, so I don't think we've got much geographic risk-based pricing... yet. But it suggests that the doors are open for that to come in the future. (To be sure, some investors might want geographically diversified pools...but not all will.)

Also it's worthwhile noting something else. The WSJ suggests that it's better to have private capital loan directly than go through Fannie and Freddie. I've explained above why that may not be the case. But the question it begs is why is the private capital flowing here, and not to direct mortgage lending (which is certainly possible) or to private-label securitization? The WSJ suggests that it is because of an implicit government guaranty. I think that's nonsense. If there are credit losses that go up to the mezzanine tranches, the investors here will take their loses. They aren't getting bailed out because they total dollar figure at risk (which is more than likely losses) is too small to matter in the economy.

Instead, I think the answer relates to (1) Fannie and Freddie economies of scale and specialization, (2) Fannie and Freddie oversight of servicers (which while not great is better than in the private-label world, and (3) Fannie and Freddie underwriting standards. In particular, #2 and #3 combine in terms of enforcement of representations and warranties about the securitized loans. Fannie and Freddie have generally been better at enforcing repurchases than trustees for private-label securitizations. (I'm not saying that Fannie and Freddie have been as vigorous as they could be...) That matters to investors who want to be sure that they are incurring only those risks that they chose to incur. Simply put, unless reps and warranties are honored, securitization does not work. And that's the lesson with the failure of the private-label market. The reps and warranties were often breached in the first place, and then too often not enforced thereafter. That will kill a market. 

Comments

[Reverb]

Fourth to last sentence, securitzation does "not" work I think you meant to say

[Adam Levitin]

Thanks! Corrected.

[Richard Davet]

"2) Fannie and Freddie oversight of servicers (which while not great is better than in the private-label world, and"

Certainly you jest.

The GSEs were/are complicit in fraud on American Courts.

I have gone through 20 years if litigation on the subject. The GSE Business Model makes Madoff look like a piker.

We need a guy like Irving Picard on this sham Model, he has set the template for dealing with those "who knew or should have known".

First we have it call it what it is ----a "theft by deception scheme" with the American taxpayers as victims. A business model called "fatally flawed" by every creditable scholar. It is illegal to sell something which does not fulfill the basic functions advertised. Then we can charge a guy like Picard to apply the Madoff template.

[Christian s Herzeca]

"Fannie and Freddie have generally been better at enforcing repurchases than trustees for private-label securitizations."

indeed. PLS trustees are repeat players beholden to issuers rather than their fiduciaries, the investors. only GSEs actually defend against originnator moral hazard

[IC_deLIght]

Adam,
One of the problems with these schemes is that the investors in the CDOs need protection against a credit default by the holder of the loan as well (there is a SWAP after all). When the protected party is a bank, the trustee for the CDO may require the bank transfer the asset (loan) to another entity to be held in trust for the bank. Often this is the trustee of the CDO. Now the bank is no longer the holder of the loan but rather at best a beneficiary. Now they will lie in foreclosure proceedings but the reality is that the bank is not the entity with the ability to foreclose - it is now the trustee that is holding the loan. If Fannie & Freddie are going to be participating in these schemes, who is going to be holding the loans? GSEs are already under a federal conservatorship - or are structured CDOs going to just look the other way since they can count on the federal government to be the protection against default by Fannie Mae or Freddie Mac?

[Adam Levitin]

@ Richard Davet--I only made a comparative point. GSE servicing is plenty problematic as an absolute matter.

@ IC_deLIght--I think you're confused about the transaction. The protection seller is the CDO; the protection buyer is Fannie/Freddie. The loans in this case remain on Fannie/Freddie's books, and Fannie and Freddie retain whatever legal rights they have to the loans. The loans are not held in trust for the CDO. The CDS on the loans are entirely separate contracts.

[IC_deLIght]

Adam,
In theory the loans are supposed to remain on the books of the protection buyer. However, there is a swap involved and the protection seller must protect against the possibility of bankruptcy or credit default of the protection buyer that might create a default in the premium payments. Look at transactions such as the Real Estate Investment Securities, Inc., Series 200X, e.g.,
https://www.moodys.com/research/MOODYS-RATES-REAL-ESTATE-SYNTHETIC-2004-B-DEAL--PR_83915

The loans did not stay with the Protection Buyer, rather they were transferred to a trustee in trust for the Protection Buyer. Mortgage notes in the reference portfolio were specially indorsed over to a trustee - which meant the Protection Buyer was no longer the holder of the note, which in turn means the Protection Buyer has no authority to foreclose typically.

[Dave]

I really feel like we're through the looking glass in these arguments against private financing of mortgages. They boil down to stating that Fannie/Freddie guarantees have driven housing prices in some neighborhoods/areas to deviate from what market risk-based pricing would, and that we ought to keep it that way. I can see that as a valid argument for why removing public guarantees through Fannie and Freddie needs to be accomplished over a lengthy period - which is necessary based on how dominant of a role they've assumed in housing finance in any case - but it doesn't dictate that we need public financing in perpetuity.

I find the geospatial correlation argument interesting but unpersuasive.

If we're talking about idiosyncratic risk of happening to live on the same block as a handful of risky neighbors, I'm not persuaded that those neighbors would necessarily have paid less for their houses. They've presumably purchased their homes in competition versus other buyers with credit profiles more typical of the neighborhood, and have therefore paid a market price broadly in-line with that set by credit availability for such buyers.

If we're talking more broadly about living in an area - at the level of a ZIP code or at least several block neighborhood - full of neighbors with risky credit profiles, then I'm already taking on risk from their credit profiles whether or not it's priced into my mortgage loan. That's because these neighbors are more likely to default, leading to the potential of a wave of foreclosures and depressed selling prices. There is also likely to be a similar risk of unsightly, poorly maintained homes proliferating in the neighborhood in the event that financially stressed neighbors struggle to afford to maintain their homes. If I'm a buyer in that neighborhood, I prefer that this risk is priced in up-front - in the form of reduced credit availability to all buyers, lowering the purchase price - rather than mortgaging up to pay an artificially higher price, with my down payment of course behind the mortgage.

As for local housing market booms and busts, we already have those. We presumably always will for the reasons that we have booms and busts in the value of all sorts of assets, exacerbated of course by the fact that houses are relatively illiquid to buy and sell, subject to delays in constructing new ones, and subject in some cases to relatively inelastic demand (people will stretch to buy when prices are going up, and even a huge drop in prices doesn't make my decide that I can really use two homes in the same city).

As for a regional shortage of private capital in the housing market in the pre-GSE era, that was also the era before interstate branch banking. We now have truly national banks and far more developed capital markets. We don't have regional shortages of other forms of consumer credit or commercial real estate financing, so I don't see why we would have regional shortages of private housing finance.

As for arguments based on real estate taxes, that's very much letting the tail wag the dog. Localities would be well-served to try to smooth changes in real estate taxes in any case. There's no particular reason to think that per capita cost of government, or taxpayer's ability to bear taxes, has gone up by 15% just because house values have gone up 15% in a year. It's a pernicious myth for people to think that real estate values drive local property taxes. Cost of government is the real driver, and the property tax rate can be (and should be) an output of dividing the cost of government (to be financed by real estate taxes) by the total assessed value of property. One can move closer to this goal by using one of various defaults for property taxation. Two options are either applying a rate to a multi-year moving average of property value, or limiting annual moves up or down to no more than something like 5% to 10% per year with the potential for "catch-up" in subsequent years.

[Richard Davet]

“@ Richard Davet--I only made a comparative point. GSE servicing is plenty problematic as an absolute matter.”

I am wondering why we are discussing resuscitation of the “zombie” , fatally flawed business model?

Simply put, the GSE Business Model does not work for a million reasons if you have a problem getting by the first one (the government guarantee of their MBSs).

Now Fannie suggests a “synthetic CDO”? Like a discussion of rearranging the deck chairs on the Titanic.

It should be crystal clear to us all that you cannot believe the Lord’s Prayer out of these people.

Case in point, see the link to the FNMA Certificate of the corporate secretary, circa 1998:

https://www.scribd.com/doc/294670550/Fnma-certificate-051398

Note: “Fannie Mae relies on the information reported by a servicer to maintain its records.”

Now we all know about the predatory conduct of fnma servicers in buttering their own bread, however a larger question looms. How can FNMA rely on any numbers furnished by a mischievous contractor/servicer? The numbers furnished rendered FNMA’s financials worthless, violating GAAP and not worth the paper they were written on.

In the event you are wondering, FNMA demanded my prime mortgage be purchased by their errant contractor/servicer Nationsbanc (BAC) ---three years after they falsely claimed in Ohio court that they were the “owner and holder” of my mortgage. In Ohio to have standing to file for foreclosure, you must be the “holder” when commencing the suit (Schwartzwald). FNMA tacitly approved this fraud on Ohio courts by not demanding of their contractor/servicer that I be made whole as a result of this fraud on the courts. This is contrary to the representations made by Management to the FNMA Board of Directors in the Baker Hostetler Report (fraud by servicers).

http://s3.documentcloud.org/documents/289482/lavalle-report-small-printed.pdf