Transferring Credit Risk On Mortgages Guaranteed By Fannie Mae Or Freddie Mac

from the Congressional Budget Office

Fannie Mae and Freddie Mac are government-sponsored enterprises (GSEs) that help finance mortgages in the United States. They were originally established by the federal government as private corporations with a public mission. However, in September 2008, the government placed the GSEs in conservatorships under their regulator, the Federal Housing Finance Agency (FHFA), because of financial distress stemming from the recession that began in 2007.

Today, under those conservatorships, the debt securities and mortgage-backed securities (MBSs) that Fannie Mae and Freddie Mac issue are effectively guaranteed by the federal government (subject to limits). That guarantee explicitly exposes the government to risk from the activities of the GSEs.

Fannie Mae and Freddie Mac operate mainly in the secondary (or resale) market for single-family mortgages. They buy mortgages that meet certain standards from banks and other mortgage originators; pool those loans into mortgage-backed securities, which they guarantee against most of the losses from defaults on the underlying mortgages; and sell the MBSs to investors – a process known as securitization. The GSEs’ guarantees on MBSs provide insurance to investors that they will receive payments of principal and interest on the underlying mortgages even if a borrower defaults. Some of the other losses from defaults on those mortgages are borne by private mortgage insurers. However, on most of the loans pooled into MBSs, the GSEs – and thus the federal government – bear a significant share of the risk of losses as part of their traditional guarantee operations.

How Do the GSEs Share Risk With Private Investors?

At the direction of FHFA, the GSEs began undertaking transactions in 2013 to transfer some of the credit risk of their guarantees to private investors. In most of those transactions, the GSEs issue bonds, called credit-risk notes, that pay principal and interest to investors based on the performance of an underlying pool of mortgages guaranteed as part of traditional MBSs. Credit-risk notes insulate Fannie Mae and Freddie Mac from a specified amount of mortgage losses by having those losses reduce the amount of principal repaid to holders of the notes. The GSEs have also experimented with reducing their exposure to credit risk by issuing subordinate MBSs that they do not guarantee, by having mortgage originators retain some of the risk on the loans sold to the GSEs, and by purchasing reinsurance on pools of mortgages.