[Senate Hearing 113-221]
[From the U.S. Government Publishing Office]


                                                        S. Hrg. 113-221

 
                  HOUSING FINANCE REFORM: FUNDAMENTALS OF 
                    TRANSFERRING CRED IT RISK IN A FUTURE 
                    HOUSING FINANCE SYSTEM
=======================================================================



                                HEARING

                               before the

                              COMMITTEE ON
                   BANKING,HOUSING,AND URBAN AFFAIRS
                          UNITED STATES SENATE

                    ONE HUNDRED THIRTEENTH CONGRESS

                             FIRST SESSION

                                   ON

EXAMINING THE CONCEPT OF RISK SHARING CONSIDERED IN THE CONTEXT OF THE 
HOUSING FINANCE MARKET AND THE RISK TRANSFER TRANSACTIONS ENTERED INTO 
                     BY FANNIE MAE AND FREDDIE MAC

                               __________

                           DECEMBER 10, 2013

                               __________

  Printed for the use of the Committee on Banking, Housing, and Urban 
                                Affairs


                 Available at: http: //www.fdsys.gov /




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            COMMITTEE ON BANKING, HOUSING, AND URBAN AFFAIRS

                  TIM JOHNSON, South Dakota, Chairman

JACK REED, Rhode Island              MIKE CRAPO, Idaho
CHARLES E. SCHUMER, New York         RICHARD C. SHELBY, Alabama
ROBERT MENENDEZ, New Jersey          BOB CORKER, Tennessee
SHERROD BROWN, Ohio                  DAVID VITTER, Louisiana
JON TESTER, Montana                  MIKE JOHANNS, Nebraska
MARK R. WARNER, Virginia             PATRICK J. TOOMEY, Pennsylvania
JEFF MERKLEY, Oregon                 MARK KIRK, Illinois
KAY HAGAN, North Carolina            JERRY MORAN, Kansas
JOE MANCHIN III, West Virginia       TOM COBURN, Oklahoma
ELIZABETH WARREN, Massachusetts      DEAN HELLER, Nevada
HEIDI HEITKAMP, North Dakota

                       Charles Yi, Staff Director

                Gregg Richard, Republican Staff Director

                  Laura Swanson, Deputy Staff Director

                   Glen Sears, Deputy Policy Director

              Erin Barry Fuher, Professional Staff Member

                  Kari Johnson, Legislative Assistant

                  Greg Dean, Republican Chief Counsel

            Chad Davis, Republican Professional Staff Member

                Hope Jarkowski, Republican SEC Detailee

                       Dawn Ratliff, Chief Clerk

                       Taylor Reed, Hearing Clerk

                      Shelvin Simmons, IT Director

                          Jim Crowell, Editor

                                  (ii)
?

                            C O N T E N T S

                              ----------                              

                       TUESDAY, DECEMBER 10, 2013

                                                                   Page

Opening statement of Chairman Johnson............................     1

Opening statements, comments, or prepared statements of:
    Senator Crapo................................................     2

                               WITNESSES

Kevin Palmer, Vice President, Strategic Credit Costing and 
  Structuring, Freddie Mac.......................................     4
    Prepared statement...........................................    22
Laurel Davis, Vice President for Credit Risk Transfer, Fannie Mae     5
    Prepared statement...........................................    26
    Responses to written questions of:
        Senator Crapo............................................    47
Ted Durant, Vice President of Analytic Services, Mortgage 
  Guaranty Insurance Corporation.................................     7
    Prepared statement...........................................    32
Sandeep Bordia, Head of Residential and Commercial Credit 
  Strategy, Barclays Capital.....................................     9
    Prepared statement...........................................    40
Wanda DeLeo, Deputy Director, Division of Conservatorship, 
  Federal Housing Finance Agency
    Prepared statement...........................................    43
    Responses to written questions of:
        Senator Reed.............................................    47

              Additional Material Supplied for the Record

Prepared statement of Laurie S. Goodman, Director, Housing 
  Finance Policy Center, The Urban Institute.....................    50

                                 (iii)


 HOUSING FINANCE REFORM: FUNDAMENTALS OF TRANSFERRING CREDIT RISK IN A 
                     FUTURE HOUSING FINANCE SYSTEM

                              ----------                              


                       TUESDAY, DECEMBER 10, 2013

                                       U.S. Senate,
          Committee on Banking, Housing, and Urban Affairs,
                                                    Washington, DC.
    The Committee met at 2:38 p.m., in room SD-538, Dirksen 
Senate Office Building, Hon. Tim Johnson, Chairman of the 
Committee, presiding.

           OPENING STATEMENT OF CHAIRMAN TIM JOHNSON

    Chairman Johnson. I call this hearing to order.
    This hearing is the last in our in-depth series of policy 
hearings to explore the benefits and challenges of reforming 
the housing finance system. At the urging of Committee Members 
and with the help of witnesses representing stakeholders across 
the industry, consumer, and policy spectrum, Ranking Member 
Crapo and I established an aggressive hearing schedule focusing 
on what we agreed were essential pieces for consideration in a 
new housing finance system. I would like to thank Ranking 
Member Crapo and his staff for their good partnership and 
coordination in undertaking this complicated effort. I would 
also like to thank all the witnesses that have participated. 
There are numerous players in the housing finance system that 
have structured their businesses and household decisions around 
the current system contributing to nearly 20 percent of the 
economy. As we draft changes to the system, we must keep that 
in mind.
    Witnesses in previous hearings overwhelmingly agreed that 
any new housing finance system should include an explicit 
Government guarantee with private capital taking the first-loss 
position. However, as we explored during the hearing regarding 
the transition, we must be certain that there will be enough 
interest from private capital to prevent the reduction of 
liquidity and mortgage credit. Today's hearing will examine 
several ways that private capital can take on additional credit 
risk in front of a Government guarantee and the features that 
are required to attract private capital.
    When considering options for expanding private capital's 
role in the secondary mortgage market, I believe the structures 
should be compatible with the TBA market in order to ensure 
continued availability of the 30-year fixed-rate mortgage. It 
is not clear that certain transactions envisioned by S.1217 are 
TBA compatible, but the recent credit risk transfer 
transactions conducted by Fannie Mae and Freddie Mac may 
provide one blueprint that is. I look forward to learning more 
about those transactions today and how we can improve on S.1217 
in this respect.
    I am also concerned that in a system with multiple private 
capital structures as options, not all forms of private capital 
will provide equal protection for taxpayers. As we saw during 
the recent housing boom and subsequent crisis, private capital 
will participate during a boom and flee in a downturn. If we 
are going to construct a new system that is even more dependent 
on private capital, we must work to ensure that private capital 
is stable and appropriately allocated and that any new 
structure functions well so that responsible homebuyers are not 
priced out of the market.
    Last, for any future system to function and maintain the 
trust of consumers, investors, and taxpayers, there needs to be 
clear guidelines regarding how loan modification requests are 
evaluated and how principal and interest are paid to investors 
in the event of a modification or a borrower default. I would 
like to thank our witnesses for being here today, and I look 
forward to your thoughts regarding how the different private 
capital structures could perform in various economic 
circumstances and what a new system would need to be able to 
maintain the TBA market.
    With that, I will turn to Senator Crapo.

                STATEMENT OF SENATOR MIKE CRAPO

    Senator Crapo. Thank you very much, Mr. Chairman. We made 
it to our last hearing, at least to this point, right?
    As the Committee continues to consider broad reform of the 
housing finance system, I am encouraged by the progress that we 
have made over the last few months. Since August, the Committee 
has held nine hearings on specific components that could make 
up a new housing finance system, and I appreciate the 
Chairman's initiative and perseverance and your thoughtfulness 
in working through these complex matters. I remain strongly 
committed to working with the Chairman and all of my colleagues 
toward a bipartisan solution in the near future.
    During a prior hearing, the Committee examined the 
construct for a potential Government guarantee of certain 
mortgage-backed securities. Today the Committee will take a 
closer look into the mechanics of allocating private capital 
ahead of such a properly tailored Government guarantee.
    As in prior hearings, I am going to reinforce that if we 
consider housing reform options that include a Government 
guarantee, we must ensure that there is robust private capital 
taking the first-loss position. We must also ensure that the 
first-loss positions are in front of mortgages with high-
quality underwriting.
    If there is not proper underwriting and allocation of 
private capital ahead of the Government guarantee, we could 
find ourselves in another taxpayer bailout scenario. That would 
be unacceptable.
    I welcome the perspective of our witnesses on the potential 
risk transfer options that could be used to attract private 
capital to this first-loss position, including the benefits and 
tradeoffs of each option. In particular, I am interested to 
hear your views on which risk transfer mechanisms could bring 
in an appropriate amount of private capital while still 
prioritizing taxpayer protection to the fullest extent 
possible.
    S.1217 contemplates several mechanisms for the security 
level risk transfer: bond guarantors, one of two capital 
markets approaches, as well as any risk-sharing agreements 
undertaken by the Federal Housing Finance Agency.
    The bill provides that bond guarantors would be approved by 
the Government to hold a 10-percent first-loss position against 
the covered mortgage-backed securities which they guarantee. To 
ensure that we have responsible, sustainable mortgage-backed 
securities products, the bond guarantor should stand behind 100 
percent of the principal value of the security. This means that 
the bond guarantor must exhaust all of its financial resources 
and become insolvent prior to the triggering of a Government 
guarantee. How, if at all, should legislation address allowing 
a bond guarantor to engage in risk-sharing transactions for the 
risk it takes on in absorbing the 10 percent?
    With respect to capital market transactions, one option is 
the creation of a senior-subordinated first-loss piece. Under 
this capital markets approach, S.1217 provides that the 
Government backstop would attach once the 10-percent 
subordinated piece is exhausted. Some have expressed concern 
regarding how the senior-subordinated structure contemplated in 
S.1217 would interact with the current TBA market structure. 
Could this senior-subordinated structure become TBA deliverable 
if both pieces are made up of standardized loans?
    A second capital markets option contemplated in S.1217 is a 
credit-linked note structure which allows investors to receive 
payment based on a pool's losses. Are there tradeoffs to the 
credit-linked note structure that could make it more or less 
attractive to private investors?
    I look forward to the witnesses' views on whether these 
three options could coexist in the marketplace as well as other 
options that could be attractive to private sector capital. The 
FHFA has started the experiment with risk transfer mechanisms 
this year. The Freddie Mac STACR deal and Fannie Mae's NMI and 
C-Deals are a starting point for gauging investor appetite in 
taking the first-loss position. Can these deals be replicated 
in the future? How quickly and to what extent can these 
transactions be developed? What lessons can we learn as we try 
to duplicate these risk-sharing transactions?
    I am also interested to hear from the experts before us 
today on how future risk-sharing transactions could work with a 
common utility for the securitization of covered mortgage-
backed securities. The hearings we have held over the past 
several months have allowed us to gather all relevant 
viewpoints and develop a strong, factual record.
    Mr. Chairman, again I thank you for your perseverance in 
moving ahead aggressively and for your leadership as we move 
forward on this housing reform package.
    Chairman Johnson. Thank you, Senator Crapo.
    Are there any other Members who would like to give a brief 
opening statement?
    [No response.]
    Chairman Johnson. I would like to remind my colleagues that 
the record will be open for the next 7 days for additional 
statements and other materials.
    Before we begin, I would like to introduce our witnesses 
that are here with us today:
    First, Mr. Kevin Palmer, Vice President at Freddie Mac;
    Ms. Laurel Davis, Vice President at Fannie Mae;
    Mr. Ted Durant, Vice President of Analytic Services at the 
Mortgage Guaranty Insurance Corporation;
    And Mr. Sandeep Bordia, head of Residential and Commercial 
Credit Strategy at Barclays Capital.
    We welcome all of you here today and thank you for your 
time. I would also note that Ms. Wanda DeLeo was scheduled to 
testify today, but because of the weather is unable to attend. 
Ms. DeLeo's testimony will be submitted for the record, and she 
has agreed to answer questions for the record.
    Chairman Johnson. Mr. Palmer, you may proceed.

  STATEMENT OF KEVIN PALMER, VICE PRESIDENT, STRATEGIC CREDIT 
              COSTING AND STRUCTURING, FREDDIE MAC

    Mr. Palmer. Well, thank you. Chairman Johnson, Ranking 
Member Crapo, and Members of the Committee, thank you for 
inviting me to appear today. I am Kevin Palmer. I head the 
business unit that developed and executed Freddie Mac's credit 
risk sharing transactions.
    More than 2 years ago, Freddie Mac began looking at ways to 
build tools to transfer credit risk from our books to private 
investors. Given the size of our guarantee books, we needed to 
create tools that could be scalable and sustainable. We also 
believe it is important to have multiple types of structures to 
provide flexibility to transfer risk at the lowest cost and 
with the least amount of disruption to the mortgage market.
    So we studied a variety of risk transfer options and 
structures, looking carefully at both their economics and 
whether they could be made to work operationally. This helped 
us prepare for FHFA's credit risk sharing directives in its 
2012 and 2013 scorecards.
    In 2013, we executed two different risk transfer structures 
in three transactions. We continue to explore other structures 
that meet our overall program objectives. At a high level, 
these objectives are: first, to reduce taxpayer exposure to 
credit risk of our mortgage purchases; second, bring new credit 
investors into the mortgage market; third, create innovative 
products that are both expandable and attractive over time; 
and, finally, preserve the cost efficiencies of the to-be-
announced, or TBA, market.
    I am pleased to report that we have met these objectives. 
Our first two transactions were offerings of structured agency 
credit risk debt notes. We call them ``STACR.'' We transferred 
a portion of the credit risk from more than 200,000 single-
family mortgages we recently purchases. Payments to investors 
in STACR notes are determined by the performance of this group 
of mortgages. We retained some of the risk exposure as well as 
the first-loss position. This assured investors that our 
interests and theirs are aligned. Retaining the first-loss 
position also helped investors get comfortable with STACR and 
helped make the structure more economically attractive.
    Freddie Mac retained control of the servicing of the loans. 
This ensures we can maintain high servicing standards and 
provide strong loss mitigation support to at-risk borrowers. We 
are pleased by the market response to our STACR offerings. 
Diverse groups of about 50 investors participated in each 
transaction. We announced our third risk-sharing transaction in 
November: an insurance policy underwritten by a large global 
reinsurance company. We see a lot of potential for these types 
of deals with reinsurance companies.
    Going forward, we plan on doing more STACR and reinsurance 
deals. We are also looking at other structures for risk 
sharing, including credit-linked notes, recourse agreements 
with lenders, and senior-subordinate structures.
    In summary, we are very encouraged by the strong investor 
interest in our risk-sharing offerings. We believe we can 
create products that are scalable and attractive to investors.
    Let me conclude with three key lessons that should be 
helpful to you as you consider these issues.
    First, we do not yet know how much mortgage credit risk 
sharing investors are willing to do in the long term, 
particularly during market and economic downturns. Our 
offerings were successful, in large part because conditions 
today are highly favorable for investment in mortgage credit 
risk. House prices are generally appreciating, and credit 
quality is high by historical standards. But we also have seen 
in recent history that investors can and will leave the 
mortgage market when conditions are less favorable.
    Second, we have encountered a number of regulatory, tax, 
and accounting issues that either affected the interest of 
certain investors in our offerings or influenced how we 
structured those offerings. I detail these in my written 
statement. We believe Congress should consider these and other 
similar issues as it determines the role that credit risk 
sharing instruments can play in any future housing system.
    Finally, risk-sharing transactions should continue to be 
designed to be compatible with the forward mortgage market, 
which provides key benefits to both borrowers and lenders.
    Thank you again for this opportunity to appear today, and I 
look forward to any questions.
    Chairman Johnson. Thank you.
    Ms. Davis, you may proceed.

   STATEMENT OF LAUREL DAVIS, VICE PRESIDENT FOR CREDIT RISK 
                      TRANSFER, FANNIE MAE

    Ms. Davis. Chairman Johnson, Ranking Member Crapo, and 
Members of the Committee, thank you for the opportunity to 
testify today. My name is Laurel Davis, and I am the Vice 
President for Credit Risk Transfer at Fannie Mae. My testimony 
today will address how we manage our credit risk and our recent 
credit risk transfer transactions.
    Fannie Mae assumes credit risk on the loans in the 
securities we guarantee. That means if a loan we guarantee goes 
into default or foreclosure, Fannie Mae takes the resulting 
losses. Since the onset of the housing crisis, Fannie Mae has 
made numerous improvements to how we analyze our credit risk 
and to our underwriting and servicing standards to reduce such 
risk. We also made significant improvements to how we monitor 
the origination processes of our lender customers.
    As we have upgraded our credit policies and monitoring, the 
performance of loans that we acquire has improved dramatically. 
Loans originated since 2009 have been performing well and are 
approximately 75 percent of our total book of business today. 
As a result of our efforts and an improved housing market, we 
have recorded seven straight quarters of profit and, as of 
December 31st, we will have paid almost $114 billion in 
dividends to the Treasury Department versus total draws of 
approximately $116 billion.
    Prior to bringing our credit risk transfer transactions to 
market, we spent significant time with investors and mortgage 
insurance, or MI, companies to educate them on our credit and 
servicing policies. A strong understanding of these policies 
was important to the success of these transactions. This was 
important because investors understood that Fannie Mae was 
acting as their counterparty and as an intermediary between 
originators with whom we do business and investors in the 
securities. This intermediary role makes these types of 
transactions possible. It allowed the 77 investors in the 
securities to rely on our infrastructure and standards rather 
than understanding the standards of more than 1,000 lenders 
with whom we do business. Fannie Mae also serves as an ongoing 
and active credit risk manager on behalf of itself and the 
investors.
    We have brought two credit risk transfer transactions to 
market in the second half of this year. One was a securities 
transaction and the other a mortgage insurance contract to 
provide deeper MI coverage. These transactions involved the 
sale of mezzanine risk and sought to reduce our exposure to 
unexpected losses on loans we have acquired. They also provide 
an additional avenue for private capital to enter the mortgage 
market.
    We structured both transactions to meet a number of goals, 
including having no impact on how a loan is serviced, to ensure 
that borrowers have access to the full range of refinance and 
foreclosure prevention options, to require no changes to lender 
operations, and to preserve a TBA execution. The TBA market is 
a well-functioning and liquid market that allows borrowers to 
lock in mortgage rates in advance and originators to hedge the 
associated risk.
    The securities transaction was the first offering in our 
Connecticut Avenue Securities Series, or our C-Deals. In this 
transaction, investors purchased a portion of credit risk on a 
reference pool of recently originated loans. The reference pool 
in this first C-Deal transaction included approximately 112,000 
loans totaling $27 billion in unpaid principal balance, which 
were acquired in the third quarter of 2012. These loans 
accounted for approximately 12 percent of the acquisitions in 
that quarter.
    As the loans in the reference pool are paid off by 
homeowners, Fannie Mae will pay down the principal balance of 
the C-Deal securities. If there are credit events on loans in 
the reference pool such as default or foreclosure, investors 
may experience losses in their investment.
    Fannie Mae retained a first-loss portion in an amount that 
represents a multiple of our expected losses. We sold two 
tranches of mezzanine risk and retained the senior risk in the 
structure. We also retained a portion of the mezzanine risk in 
an effort, at least initially, to keep additional skin in the 
game.
    As I noted earlier, we also entered into a mortgage 
insurance agreement with National Mortgage Insurance, or NMI. 
This was a back-end MI contract on a group of loans that 
totaled approximately $5 billion in unpaid principal balance. 
The loans included in this transaction had loan-to-value 
ratios, or LTVs, of 70 to 80 percent. In this transaction, 
Fannie Mae's liability has been reduced to 50-percent LTV on 
the covered loans. Under the contract, Fannie Mae will take the 
first loss up to 20 basis point or $10.3 million. This amount 
is over two times our expected losses on the covered loans. NMI 
will be liable for the next $90 million in losses, and Fannie 
Mae will then be responsible for any additional losses on the 
loans. The first and mezzanine risk pieces were set at a level 
that exceeds our projected losses in a stress scenario similar 
to the 2006-12 timeframe.
    We are very pleased with the reaction to these transactions 
from market participants. We are currently working on bringing 
another C-Deal transaction to market in January, and we will 
continue to look for opportunities to execute other risk-
sharing transactions.
    Thank you again for this opportunity to testify before the 
Committee, and I look forward to answering any questions you 
may have.
    Chairman Johnson. Thank you.
    Mr. Durant, you may proceed.

 STATEMENT OF TED DURANT, VICE PRESIDENT OF ANALYTIC SERVICES, 
            MORTGAGE GUARANTY INSURANCE CORPORATION

    Mr. Durant. Thank you, Chairman Johnson, Ranking Member 
Crapo, and Members of the Committee. MGIC created the modern 
private mortgage insurance industry in 1957, and we created the 
modern bond insurance industry in 1971. We have experienced the 
best and the worst of times in housing finance, and we hope 
that our experience will be helpful as you contemplate reform.
    We believe that having survived the recent housing crisis 
and saved taxpayers $40 billion, the private mortgage insurance 
model has proven its value and earned its inclusion in S.1217 
as a fundamental component of a new housing finance system. We 
would like to discuss today how private MI integrates with 
other risk transfer mechanisms to create a housing finance 
system in which mortgages are both affordable and widely 
available through the cycle and taxpayer risk is truly remote.
    S.1217 identifies several potential credit risk transfer 
mechanisms and the entities that might provide them. However, 
we suggest improvement in five areas.
    First, legislation should clarify the roles and the 
responsibilities of the bond guarantors and the mortgage 
insurers. Bond guarantors should operate at a remote risk 
level, guaranteeing the timely payment of principal and 
interest to bond holders should the issuer fail. Mortgage 
insurance operates primarily at the loan level, taking a first-
loss position on higher-risk loans and, importantly, providing 
critical oversight of the underwriting and servicing of those 
loans.
    In addition, mortgage insurers offer pool insurance to 
provide a cost-effective means of filling any gaps between 
loan-level insurance and bond insurance. Mortgage insurance and 
bond insurance should be kept distinct from each other and 
viewed as complementary not competing forms of credit risk 
transfer. As long as the appropriate distinctions and rules are 
maintained, we expect investors to find both businesses 
attractive.
    Second, legislation should recognize the private capital 
benefit that is provided by mortgage insurance. A subordinated 
securitization structure provides a deceptively simple measure 
of private sector capital at risk. Insurers provide substantial 
loss-absorbing resources with a combination of capital, 
reserves, and renewal premium, or guarantee fees. The formula 
for counting up the private sector capital at risk must include 
the resources provided by primary and pool MI.
    Third, legislation should establish a clear preference for 
using properly regulated and capitalized entities which are 
dedicated to the business of identifying, assuming, and 
managing credit risk through the economic cycles. The illusion 
of a ``best execution'' cost advantage of structured 
transactions is, in reality, the mechanism that creates the 
boom-bust cycle, providing too much credit in a boom and no 
credit in a bust.
    To ensure a stable source of capital and proper regulation 
of mortgage and bond insurers, we recommend the continued use 
of State insurance regulators, reserving for FMIC the role of 
counterparty risk management and monitoring. Regulation of bond 
insurers or mortgage insurers by FMIC raises significant 
Federal-State questions, adds further complexity to the 
management of FMIC, and concentrates oversight in a single 
point of failure.
    Fourth, legislation should clarify the manner in which the 
Government guarantee is implemented. Stepping in when a 
subordinated tranche expires and stepping in when a guarantor 
fails are very different. Individual securities are far more 
likely to reach a specified loss level than thousands of 
securities guaranteed by an entity. Stepping in at 
predetermined loss level, for example, on a vintage basis will 
create the optics of a bailout, but it will also create a 
greater likelihood that the guarantors are able to continue in 
business through a crisis. Such an approach, however, must take 
into consideration both mortgage insurers and bond guarantors.
    Fifth, legislation must comprehensively address housing 
finance reform. We at MGIC are less concerned about the 
absolute level of the capital requirement than we are about 
unequal capital requirements that favor one form of financing 
over another. Setting higher capital requirements and 
attachment points makes the taxpayer risk more remote, but it 
also translates into higher costs for borrowers and increased 
motivation for lenders to fund loans through alternative 
channels.
    The current system divides the mortgage world into 
Government and conventional lending silos. Reform efforts in 
one silo merely encourage the shift of loan production into the 
other silo. Reform should provide for consistent, uniform rules 
that apply regardless of the source of funding for the loans.
    Thank you for the opportunity to testify today. I look 
forward to your questions.
    Chairman Johnson. Thank you.
    Mr. Bordia, you may proceed.

STATEMENT OF SANDEEP BORDIA, HEAD OF RESIDENTIAL AND COMMERCIAL 
               CREDIT STRATEGY, BARCLAYS CAPITAL

    Mr. Bordia. Good afternoon, Chairman Johnson, Ranking 
Member Crapo, and other Members of the Committee. My group at 
Barclays covers research on mortgage markets, including 
research on housing finance. I appreciate the opportunity to 
discuss the fundamentals of transferring credit risk from the 
U.S. taxpayer to the private markets.
    To begin with, let me talk briefly about the credit-linked 
deals recently sold by the GSEs. So far, three deals have been 
priced. In each of these deals, the GSEs retained the risk in 
the first 0.3-percent loss position and sold the credit risk on 
the 0.3- to 3-percent loss position.
    The structures were well received by the market, with 
several dozen investors participating. To be successful, any 
solution used to transfer mortgage credit risk to the private 
market should have certain basic features. The solution should 
preserve the well-functioning TBA market, should be simple, and 
use existing financial technology. The credit-linked note 
structure satisfies all these three conditions.
    The initial response from the market is also positive. 
However, a few more things need to happen for this program to 
be successful in the long run.
    Number one, since there are fixed costs for investors to 
set up systems to analyze and track performance of these deals, 
we need to feel assured that these deals are not one-offs and 
the program is here to stay. So issuance should be programmatic 
with limited experimentation in structures.
    Number two, expanding the type of collateral on which 
credit risk is sold is critical. The initial deals covered only 
the cleanest portion of GSE originations that is not fully 
representative of the collateral quality that any future entity 
would be expected to guarantee over time.
    In terms of the market appetite to absorb the risk, while 
the initial three deals have been oversubscribed, the amount of 
credit risk sold so far is minuscule in comparison to what the 
GSEs have on their guarantee books. I believe that the market 
can absorb $5 to $10 billion of such supply next year and even 
greater numbers in later years. However, for the program to get 
to a stage where it can absorb much of the mortgage credit risk 
with GSEs, it would realistically take several years.
    As for the attachment point for the Government entity, it 
is a function of the policy goal and also the collateral 
quality on which the credit risk is being sold. The attachment 
point would be higher if the policy goal is to prevent taxpayer 
losses even in extreme draconian scenarios. And it should also 
be higher for worse credit pools. In my view, a constant 
attachment point for all kinds of collateral, as discussed in 
Senate bill 1217, may not be most optimal.
    There are two other approaches that are being considered 
for transferring credit risk from a Government-sponsored 
entity. The first is to use a securitization style senior-sub 
structure, and the second is to use well-capitalized bond 
guarantors to cover losses.
    A senior-sub structure is less preferable to a credit-
linked note such as it would entail a difficult transition from 
a well-functioning TBA market. A senior-sub structure could 
also increase the warehousing costs for originators, which 
would be particularly problematic for smaller originators.
    The other option is to use bond guarantors as providers of 
first loss. On the positive side, a bond guarantor solution 
would likely provide more stable funding for mortgage credit 
than other options. However, the bond guarantor structure also 
has two major drawbacks.
    Number one, this form of insurance may result in some 
counterparty credit risk to the taxpayer. The STACR/CAS deals 
provide the GSEs with up-front cash available to protect 
taxpayers from losses. Bond guarantors would not have to pay 
anything up front and, as such, may not work as a safeguard 
under certain conditions.
    The second drawback is that the bond guarantee structures 
would be less transparent and provide slower market feedback 
than credit-linked notes.
    In conclusion, while we favor the credit-linked structure, 
given the size of credit risk transfer required over the long 
run, it might be preferable to have multiple exit options 
including through bond guarantors. We would caution policy 
makers to closely watch the pace of any big transition.
    Chairman Johnson, Ranking Member Crapo, and other Members 
of the Committee, I thank you for your time and attention and 
the opportunity to testify before the Committee. I look forward 
to answering any questions you may have.
    Chairman Johnson. Thank you. Thank you all for your 
testimony.
    As we begin questions, I will ask the clerk to put 5 
minutes on the clock for each Member.
    Ms. Davis, what elements of your risk-sharing were most 
important to preserve the TBA market? Were there structures 
that you considered but eliminated because they were 
incompatible with the TBA market?
    Ms. Davis. Thank you. Yes, we have been working on this 
looking at various alternatives for credit risk transfer over 
the past year and a half, almost 2 years, and we did look at a 
variety of different structures as we decided what to do.
    We considered a cash senior-sub style deal as well as the 
credit-linked note. Ultimately, at least initially, we decided 
against the cash senior-sub deal because of the very point that 
you make. It would not have been compatible with the TBA 
market.
    With the credit-linked note, we can allow the loans to go 
into TBA. That market provides the funding for the loans so 
that the interest rate risk is transferred off to investors. 
The loans are funded through a very deep, liquid market. We can 
then sell the credit risk to a different set of investors, and 
it does tend to be a different set of investors who are 
interested in purchasing the interest rate risk versus the 
credit risk on the loans. And so by using the credit-linked 
note structure, we are able to keep that front end of the 
market functioning. Borrowers can lock rates. Lenders can hedge 
their pipeline. And yet we are able to still tap into the 
credit markets and offload the credit risk. So that is why we 
chose this particular structure.
    Chairman Johnson. Mr. Palmer, the risk-sharing deals that 
have been executed rely on large reference pools of loans with 
at least 20-percent downpayments and 9 months of seasoning. 
Also, the enterprises retain both the first-loss and a vertical 
strip of the risk exposure.
    Should legislation include flexibility regarding the 
features of risk-sharing deals in a new system?
    Mr. Palmer. Thank you. Yes, it is important, I think as 
indicated in my oral statement, to have flexibility in risk-
sharing transactions. As you said, the risk-sharing 
transactions that we have done initially were focused on 60 to 
80 LTV loans. I think the focus in 2013 was building structures 
where you could transfer credit risk, and using those same 
structures, we now have an ability to transfer, you know, 
different types of credit risk, which will be a focus going 
forward.
    Flexibility on the types of structures is important. We are 
in a certain unique environment today with very good 
underwriting standards, with home prices appreciating, and what 
works today may not work or be optimal in other types of 
environments, and retaining that flexibility we believe is very 
important.
    Chairman Johnson. Mr. Bordia, your testimony suggests that 
capital levels proposed in S.1217 may be difficult to achieve. 
What are the risks of setting capital at such high levels?
    Mr. Bordia. I think there are a couple of issues that we 
are trying to resolve when we have a 10-percent capital 
assigned for all different kinds of collateral types.
    Number one, if you are looking at really good quality 
collateral, then the expected losses might only be 20, 30, or 
40 basis points, and at that point, if you want the entity who 
is insuring those mortgages to retain 10-percent capital, then 
the return on that particular capital is going to be really 
small.
    So I think in some ways we are trying to strike a balance 
between protecting the taxpayer, and if you want to do that, 
then you want to have a lot of capital cushion. But at the same 
time, it will also lead to lower returns and, therefore, it is 
going to be harder to raise capital, that amount of capital.
    So just to give an example, if you look at the total size 
of the mortgages which the GSEs are guaranteeing today, it is 
around $4.5 to $5 trillion. A 10-percent requirement on that 
would roughly be around $400 to $500 billion in capital, which 
is a very, very big number. If you look at the total amount of 
money that was raised in IPOs in the U.S. this year, it was 
around $50 billion. If you look at just financial services 
firms, it was around $10 billion.
    So, yes, I think it is certainly possible over time that 
you create a market where you have a significant amount of 
capital that has been raised. It is a very, very difficult 
proposition.
    Chairman Johnson. Mr. Durant, when considering the 
different methods of risk transfer for mortgage credit, what 
are the key issues to keep in mind?
    Mr. Durant. We would say separating out the distinction 
between protecting loans at the loan level, issuing credit 
enhancement with the origination of the loans versus the 
guaranteeing of the security-level enhancement. You need both. 
Loans down to, say, a 60 LTV level, those are very safe loans. 
You do not have to be as worried about loan-level credit 
enhancement. But when you get to lower downpayments and other 
risk factors on loans, you certainly do want to make sure that 
the loans are, at the time they are originated, looked over by 
entities like mortgage insurance companies who review the 
underwriting and ensure that the credit enhancement is in place 
prior to that loan entering into the securitization world.
    Chairman Johnson. Senator Crapo.
    Senator Crapo. Thank you, Mr. Chairman.
    Mr. Bordia, in your testimony you discuss the need to have 
a wide variety of options for moving mortgage credit risk into 
the private market as opposed to limited options. Could you 
explain the reasoning for that a little better? I assume that 
if we are too restrictive in the options that market 
participants have to satisfy private capital requirements, we 
would risk diminishing the appetite of the market to move 
private capital into the market. But could you explain that 
dynamic a little better?
    Mr. Bordia. I think I will refer to some of the things that 
I mentioned in answering the previous question. So if you are 
trying to insure close to $5 trillion worth of mortgages, then 
you need a lot of capital. We have seen about $1.8 billion of 
sales in credit-linked notes from GSEs this year, and they were 
massively oversubscribed. But to assume that you can go next 
year and sell $15, $20, or $30 billion of those kind of notes I 
think it is practically not possible.
    So the main reason when I say that, you know, we need to 
look at multiple options is because it is a limited amount of 
capital chasing different kind of assets on the fixed-income 
side. We have about $850 billion of nonagency still 
outstanding, and those nonagency securities have about $60 or 
$70 billion in paydowns. And to the extent that all of those 
investors have mortgage credit expertise, you could assume that 
some part of that $60 or $70 billion comes into the 
marketplace. But if you try to do anything more than that, it 
is going to be complicated.
    Then there is also another set of investors on the equity 
side which can basically--where you can also raise money and do 
something using the bond guarantors.
    Senator Crapo. Thank you. And, Mr. Palmer, you indicated in 
your testimony that there are a number of regulatory, tax, and 
accounting, I guess I will call them, ``barriers''--I do not 
know if you used that word, but it sounded to me like that is 
what you were saying--to effectively creating the necessary 
instruments and risk management procedures that we need to 
engage in. Could you elaborate on that a little bit?
    Mr. Palmer. Sure. We spent quite a bit of time working on 
the structures that we came to market with this year, and I 
think over the course of the 2 years that we worked on it, we 
definitely ran into a number of regulatory issues, either 
proposed or new rules that have come out. A couple key ones 
that I want to mention that I refer to also in my written 
testimony is, you know, we referred to the transactions that 
have been done as credit-linked notes. They were actually, in 
fact, not credit-linked notes. They were debt offerings of the 
GSEs, and that was because of a new ruling that came down under 
the CFTC in 2012 that would have deemed these type of credit-
linked notes as commodity pools. You know, we have engaged with 
FHFA and with Fannie Mae in conversations with the CFTC to 
ensure that we can be fully compliant with those rules. And we 
hope to ultimately move to a more traditional credit-linked 
note.
    The importance there is that right now the structures that 
we are doing, investors are taking counterparty risk to the 
GSEs. Moving to a credit-linked note, you capture all of the 
cash up front in a bankruptcy remote trust, which protects both 
Freddie Mac and the investor from counterparty risk. So we 
think it is an important thing to move to in this credit-linked 
note structure.
    Second, we think it is important for these securities to 
have, I will call it, ``equal treatment'' from a tax and a 
regulatory as others. So there have been some discussions here 
about senior-subordinate securitizations. There are some pros 
and cons there. One of the key cons is the lack of 
compatibility relative to the TBA market.
    Investors today that invest in a senior-subordinate 
security are able to get--they treat it as a REMIC, which has 
more favorable tax treatments under that rule, and having a 
credit-linked note that is structured very similar to a senior-
subordinate, having similar tax treatment for investors, both 
domestic REITs are the common investors as well as foreign 
investors, is important to know.
    Senator Crapo. All right. Thank you. You identify some 
problems in getting through the complexity here, but it is 
important that we get it right.
    Mr. Durant, the last part of your testimony this afternoon 
related to the necessity that reform be comprehensive in the 
sense that, if I understood you right, we need to be sure that 
all loans are subject to the same capital requirements. Could 
you expand a little bit on your comment there?
    Mr. Durant. Sure. Clearly you have to think about capital 
that is required for loans that are held on balance sheets at 
banks versus within S.1217 is a 10-percent subordination level 
equivalent to a bond guarantor being required to be capitalized 
to a 10-percent level. Clearly, those are not the same things.
    More importantly, I think we also have to also think about 
FHA, VA, and Ginnie Mae and how does all of this interact with 
FHA financing in particular. The changes we make to the rules 
around a Government-guaranteed section replacing Freddie and 
Fannie clearly are going to potentially drive loans back into 
FHA-VA lending.
    Senator Crapo. All right. Thank you.
    Chairman Johnson. Senator Tester.
    Senator Tester. Thank you, Mr. Chairman. I want to thank 
both you and the Ranking Member for your work in holding these 
hearings. I think that they have been helpful, and I think that 
as a result there is some pretty significant progress, so I 
want to thank you both.
    This is for Mr. Palmer and Ms. Davis. What guidance or 
advice regarding how to structure credit risk transactions 
would you provide to the future FMIC Director as conceived in 
S.1217, the Corker-Warner bill, based on your experiences in 
structuring such transactions at the enterprise that you have 
been through?
    Mr. Palmer. Yes, I think the guidance that I would provide 
is, one, and it has been talked about here--that we need 
multiple types of options. Just within the two GSEs, there's $5 
trillion of guaranteed mortgages on our books, or maybe just 
under that. To be able to transfer that amount of risk to the 
markets I think you need to have multiple types of tools, as 
well as in a variety of different economic markets being able 
to use some tools more than others.
    I think, second, it is important to think about 
holistically the various different regulatory rules as it 
relates to housing reform to ensure that it balances the need 
to be able to transfer credit risk to private markets as well 
as kind of the appropriate governance and controls for a 
sustainable market.
    And then, last, it is important to preserve a forward 
market that we have discussed, the TBA market, which is what we 
have today, that provides key benefits to borrowers and 
lenders.
    Senator Tester. Ms. Davis, anything to add?
    Ms. Davis. Sure. I definitely agree with Mr. Palmer in 
terms of what we learned about the TBA market and the fact that 
if you just think about the scalability of the types of 
programs that we are looking at here, the fact that you can tap 
into TBA for the funding of the loans and think about, you 
know, as I mentioned in my testimony, we sold risk on $27 
billion worth of loans, but the securities amount that we 
issued was $675 million. So we were able to actually issue a 
much smaller amount of securities in order to cover that large 
amount of loans because of the fact that the loans had already 
previously been funded through TBA.
    I think the second thing that I would add is one of the 
things that we learned definitely was the importance of the 
role of an intermediary in the transactions. As we went out on 
our road shows, investors were very interested in understanding 
how we originate the loans, what our credit policies are, what 
the QC standards are on the loans, how we will service the 
loans. And having that transparency around our practices and 
having that role of somebody setting those standards--and 
investors did a lot of credit work on these deals. We spent a 
lot of time educating the rating agencies. We spent a lot of 
time educating investors on what is in our guides, selling and 
servicing guides, you know, how that aspect of the market 
works. We released performance data on 18 million loans, and 
investors used that to create models and understand the credit. 
And I think we found that having that intermediary role was 
very important to investors.
    Senator Tester. OK. Thank you. And anybody who wants to 
answer this can. What lessons should we draw from the response 
of market participants to the enterprises' credit risk sharing 
transactions? Go ahead, Ms. Davis.
    Ms. Davis. I will jump in and start. I think we learned 
certainly that in the current market, which Mr. Palmer pointed 
out is certainly very favorable to credit risk transfer, we 
learned that, you know, investors are interested in taking on 
mezzanine credit risk on a very high credit quality pool of 
loans, and we definitely had a very strong response. I think, 
you know, the one thing that we would keep in mind is that the 
current market is definitely very favorable.
    Mr. Bordia. I would add that I think initially, when the 
first deal came out, there was some level of skepticism in the 
market. And as it became clear that it is going to be more 
programmatic, investor interest has actually gone up. If you 
look at the execution, it has been significantly better than 
the first deal for the second and third deals. So I think 
obviously to the extent that you can make sure that everyone 
understands it is going to be a big program and you will 
continue to see these kind of securities come into the 
marketplace, it will certainly help.
    Senator Tester. OK. As conceived in the Corker-Warner bill, 
the FMIC Director would be tasked with approving credit risk 
sharing transaction structures. Under this construct, we 
believe that the bond guarantors will take on the bulk of the 
credit risk required, but also provide the FMIC Director with 
the flexibility to approve structures based on capital markets' 
execution. How do you feel about this flexibility? And do you 
think it is appropriate? Go ahead, Mr. Palmer.
    Mr. Palmer. You know, I do think that the flexibility is 
important. I think, you know, we are in the very early stages 
of credit risk transfer. Freddie Mac has done two different 
types of risk transfer structures, Fannie Mae also two 
different types, three types between the two of us. And we are 
still in the learning stages, and I think we will continue to 
be there, and continuing to have that flexibility is important.
    Senator Tester. OK. Thank you all very much.
    Thank you, Mr. Chairman.
    Chairman Johnson. Senator Corker.
    Senator Corker. Thank you, Mr. Chairman, and I thank each 
of you for being here and for your interest in the topic. I am 
sure I am going to be redundant. I stepped in from another 
setting, and I apologize.
    In the 1217 bill that many of us have talked about and been 
involved in and many of the questions end up being centered 
around, we tried to lay out a situation that does create 
flexibility, as Senator Tester just mentioned, and looks at 
various ways of having private capital through a bond 
guarantor, through credit-linked notes, through A and B pieces, 
and trying not to be too prescriptive so that all of those are 
available.
    Is it your sense--and I would like to ask all four of you 
this--that we are better off giving that flexibility and 
allowing the FMIC Director, should a bill like this pass, 
something similar, is it better for us to have that flexibility 
and for us to be able to test each of those as we move along? 
Or is it better for us to be more prescriptive and eliminate 
some of those possibilities?
    Mr. Palmer. I do think it is very important to have that 
flexibility. I think today, as I said in my oral statement, it 
is a very good market for taking on mortgage credit risk. House 
prices are generally appreciating. The underwriting quality of 
the loans is very strong. I think as we have seen in previous 
markets, sometimes the capital markets go away, and we need to 
have other options available to be able to transfer credit risk 
in a variety of different markets.
    Senator Corker. OK.
    Ms. Davis. Yes, I think we would definitely agree that the 
flexibility is important. Just relating back to the specific 
transactions that we did, we certainly looked at a variety of 
different structural options even within the credit-linked note 
structure, and just specific to these deals, early on we looked 
at sort of different points of risk to sell and should we sell, 
you know, 3 percent, 4 percent, 5 percent, the right level. And 
so a lot of it for us, the analysis came down to this 
particular pool of loans and, you know, what did we expect the 
risk to be on this particular pool of loans. And so we felt 
that, you know, this was the level that was appropriate for 
this particular pool.
    So I think just the exercise that we went through on this 
transaction showed us that you are going to have kind of 
different structures that you are going to want to use in 
response to different market conditions.
    Mr. Durant. We, too, think the flexibility is important, 
subject, of course, to the comments I made earlier about 
separating out the loan-level credit risk for the higher-risk 
loans, having that coverage placed as the loans are originated 
versus the flexibility of developing credit risk sharing at the 
security level, once you have made sure that at the loan level 
the credit enhancement is already there.
    Mr. Bordia. Well, I agree with pretty much everyone. I 
think flexibility is important. If you are looking at really 
good quality collateral, then there is no point asking someone 
to hold 10-percent capital. But then there are also collateral 
types where the average expected losses are going to be north 
of 10 percent, and if you have just 10-percent capital cushion 
for that, it is not going to be enough. So I think flexibility 
is important. I would also add that while you want to keep the 
flexibility, you want to be somewhat prescriptive. You do not 
want to give a lot of leeway in terms of what people can hold 
or cannot hold.
    Senator Corker. And speaking of that, I have one more 
question, but you a minute ago sounded somewhat negative on the 
ability to have the available capital together. If I 
understood--and I was doing something else at the time, but I 
think you were talking about fixed income. But if you were 
seeking private equity, too, and you had clear rules and you 
had time, is there any question in your mind that with clear 
rules and time and looking at the combination of all markets, 
you would have the kind of capital available to have 10-percent 
capital at risk in advance of any Government guarantee?
    Mr. Bordia. I think over time I think it is certainly 
possible. If you are looking at a collateral pool which has 
half a point of loss and you ask them--and you need 10-percent 
capital, the market will trade whatever, the first 2 or 3 
percent as equity, and you should be able to raise the 3 
percent to 10 percent at much more attractive levels. So I 
think to answer your question in short, it is certainly 
possible, but it will take a pretty long time.
    Senator Corker. And let me just ask one more question, if I 
could. I assume that the bond guarantors, if, you know, they 
are playing--if they are in this arena, they themselves also 
behind their risk are going to be accessing capital markets. 
They are going to be using, I think, as you all described a 
minute ago, they are going to be using credit-linked notes and 
subordinated components to actually lay off their 10-percent 
risk. Is that correct?
    Ms. Davis. Yeah, I think we would agree with that. You 
know, it is a little hard to extrapolate, obviously, from just 
three transactions. But I think you can look at the model that 
we used with these particular security structures where you 
could have a guarantor who then taps into the capital markets 
to lay off some of that credit risk when the markets are good. 
You know, I think the nature of those types of markets is they 
are cyclical, right? So if you have a guarantor who can then 
access those markets when they are open, take advantage of, you 
know, perhaps better pricing for credit when the markets are 
good and then that becomes a component of their risk 
management.
    Senator Corker. Well, thank you. And I think it seems like 
you all are shaking your head up and down, and so without 
belaboring the Committee, Mr. Chairman, thank you, and I thank 
each of you for your testimony.
    Chairman Johnson. Senator Warren.
    Senator Warren. Thank you, Mr. Chairman, Ranking Member 
Crapo, for doing this.
    We have been talking today about two basic ways of 
transferring credit risk: a structured transaction, here the 
senior-sub, or an investor takes the credit risk up front and 
bond insurance, which pays out on the back end if a pool of 
loans starts to go bad. And it seems like each one of these has 
some pluses and some minuses as we think them through.
    Obviously the nice thing about the senior-sub structure is 
that the money is there up front to absorb any losses. But from 
what I understand, that structure is incompatible with the TBA 
market. So if an investor is going to take on the credit risk 
of a pool of mortgages, they want to know exactly what the 
mortgages are that are in the pool. And, of course, that cannot 
happen in a TBA market.
    Is there anybody who disagrees with that?
    [Witnesses shaking heads.]
    Senator Warren. OK, good. So we are all in the same place 
on that. Good.
    Well, I do not think the Government should be standing 
behind structured transactions if those transactions do not 
work in a TBA market. The TBA market allows borrowers and 
lenders to lock in a rate in advance, critically important for 
families, for community banks, for credit unions, for access to 
mortgages.
    Now, bond insurance works with a TBA market, but since it 
pays on the back end instead of on the front end, the risk is 
that the bond insurers will not actually have the money to pay 
off if a whole deal goes south, if a whole tranche goes south. 
So if the Government is going to depend on bond insurers to 
stand before the Government guarantee, then the Government is 
going to have to be very diligent in overseeing those bond 
insurers to make sure they have enough high-quality capital to 
cover the risks that they have taken on.
    So do any of you have any ideas about the kind of 
regulatory and oversight burden that this is going to place on 
the Government? Mr. Durant.
    Mr. Durant. Sure. So we, of course, look to our existing 
regulatory environment. That is what we do today. And obviously 
people point to it and say, ``But the bond guarantors active in 
the residential finance market largely failed in this crisis.''
    Senator Warren. Yes, they do say that. For a reason.
    Mr. Durant. And, you know, one of the things we look at as 
why did that happen is, as I talked about, the separation of 
the loan-level risk, the individual loan risk, from the overall 
security risk. Bond insurance was originally designed to 
guarantee municipal bonds. In 1971, my predecessors at MGIC, 
they created that business to do that. It was adapted for use 
in mortgage-backed security financing, and people did not think 
a lot about the different loan-level risks that are present on 
individual borrowers versus a municipal bond that is backed by 
taxpayer funds. Very different kinds of things.
    So, first of all, this separation of the loan-level risk 
from the security risk we think is a very important component 
of ensuring that the bond guarantor model is going to survive.
    Now, as I talked about in my testimony, right now bond 
insurers, their insurance is regulated by the States. That is 
the way things work, and unless you want to make changes to 
McCarran-Ferguson, we kind of have to work within that 
construct.
    That said, I think particularly in the mortgage insurance 
industry, we have a very good example of how State regulation 
combined with Federal oversight that OFHEO and now FHFA and 
Freddie Mac and Fannie Mae has worked quite well. The fact is 
five of the eight mortgage insurers are still here, and, you 
know, I think that model has shown that it does work.
    Senator Warren. So, Mr. Durant, your position is there is 
adequate regulation already in this market, notwithstanding 
what has happened over the past----
    Mr. Durant. I think----
    Senator Warren. Notwithstanding the facts?
    Mr. Durant. ----the changes that are being made are 
addressing a lot of those concerns. So within the mortgage 
insurance----
    Senator Warren. So you are saying there needs to be more 
regulation.
    Mr. Durant. Different regulation, yes.
    Senator Warren. All right. Mr. Bordia, did you want to add 
anything?
    Mr. Bordia. Yes, I think there are just a couple of things 
that I wanted to add.
    So, one, to the extent that you have bond guarantors 
guaranteeing some of these securities, either do you want the 
capital that is standing behind sit in some separate reserve 
account or something like that? Because if insurers or bond 
guarantors are in five or six different lines of businesses and 
something bad happens somewhere else, then it is going to be a 
problem. The money is not going to be around to take care of 
the losses that come from Fannie Mae or Freddie Mac or any such 
future entity.
    Senator Warren. So we need some kind of regulatory 
structure around this, and this is----
    Mr. Bordia. Yes. Either you ensure that the cash is sitting 
somewhere and so you raise like 2- , 3-percent capital, then 
you raise a lot of debt, but that, for example, can only be 
used to cover losses from these entities; or you just set aside 
money right up front to take care of these losses.
    Senator Warren. So that brings me then to the final 
question and how these tie together, and that is, is there a 
viable alternative to the two approaches, structured deals and 
bond insurance? What about the proposals from the Center for 
Responsible Lending and the New York Fed for one or more 
mutuals that issue and guarantee mortgage-backed securities? 
Any thoughts on that, a third way to go about this that does 
not have this kind of regulatory structure but still supports 
the TBA market?
    Mr. Durant. I think those still will require a regulatory 
environment of some kind, and really, for example, I am more 
familiar with the New York Fed proposal. I think the idea of 
cooperatively owned and operated entities the way they have 
suggested it actually fits in quite well in the S.1217 
structure. Issuers guaranteeing their own securities is done 
every day. It is called Ginnie Mae. And so we already know what 
that looks like and how it needs to be managed.
    Senator Warren. Although part of what we get, of course, in 
a mutual is that, in effect, they regulate each other. They 
become self-regulating instead of the----
    Mr. Durant. If they are set up correctly, right.
    Senator Warren. ----``catch me if you can'' of other forms 
of regulation. So thank you. I appreciate it, Mr. Chairman. You 
know, I think this is a really central question when it comes 
to housing finance. Who is going to take on the credit risk of 
all these mortgages? And it is really critical we get this 
right, so thank you.
    Chairman Johnson. Senator Warner.
    Senator Warner. Thank you, Mr. Chairman. First of all, 
echoing what some of my other colleagues have said, thanking 
you and the Ranking Member for continuing to aggressively move 
these hearings forward, and we have gone through snowstorms and 
shutdowns, and obviously the focus of this Committee is to take 
on certain international issues as well. I know Senator Corker 
has been involved, and others. So I am very grateful that we 
have kept an aggressive schedule, and my hope is that you and 
the Ranking Member take some of the work that was started and 
reshape this that we can very, very early on in the New Year 
get a piece of legislation marked up and out of this Committee.
    Mr. Bordia, I think you responded a bit to--I think you 
responded affirmatively to Senator Corker that, you know, 
because of this variety of tools that would be out there, we 
could get to that 10-percent level, and I would simply point 
out as well that there are other proposals out there that get 
rid of any Government role at all that would require 
exponentially higher amounts of private capital, would you not 
agree, if you get rid of the Government role entirely, as some 
have proposed?
    Mr. Bordia. Again, I am not sure, I think, what the right 
capital required is. If you look at the total GSE portfolios, I 
am pretty certain losses on that $5 trillion portfolio are not 
$500 billion, and they have clearly gone through 2006 and 2007. 
So I am not sure, I think, what the right number is. What I was 
trying to say is that it might not be a good idea to have the 
same amount of capital, and even if you require $100 or $200 
billion of capital that has to come from the private markets, 
it will take a lot of time.
    Senator Warner. I believe what you have also said and I 
think what some of us believe is if there has been some 
overshooting and an extra buffer to make sure, again, that the 
taxpayer does not get hit with another $188 billion bill the 
way we did last time and now some people coming back and 
saying, you know, that risk exposure the taxpayer took should 
be returned at a 1:1 rate and that somehow makes everything 
whole, as a former VC, that would not be a return I would be 
happy with. But if we do have an abundance of caution here, 
there will be an ability, I think, to tranche part of that 
capital out, and as you said earlier----
    Mr. Bordia. Yes. You cannot raise all of the demand as 
equity capital.
    Senator Warner. Right. It would be priced in different 
ways. I think Senator Warren has raised, you know, some good 
components about this, the question about how we get this 
insurance component piece right, and, you know, I would point 
out that in S.1217 we do have a mutual. We would still--the 
concept of that mutual to service the portion of the market to 
make sure there is quality of pricing, we still envision the 
guarantee piece, the private capital loss piece being perhaps 
separate from that, or separate from that mutual, but we think 
we have got that in the toolbox.
    I guess one of the things, Mr. Durant, that we have 
pushed--and I think now you have had some concern about--is you 
pointed out in your testimony that you thought it was 
appropriate that the insurance function get separated from the 
loan level, from the security level, and that if we are--you 
know, going forward, and particularly if an entity is in a 
variety of these lines of business, we are going to have to 
have, you know, separate levels of characterization, separate 
structures so we do not have this overlapping problem where, if 
the string starts to get pulled on one of these lines of 
business, it does not bring down the whole house. Do you want 
to--and I do believe that it will require--and we have put some 
requirements in S.1217 to make sure--I know there is some 
pushback from you all on this, but that you do not have that 
kind of overlapping coverage.
    Mr. Durant. Yeah, I think our concern would be within a 
parent company holding structure, why wouldn't you allow a bond 
guarantor to also, you know, be a sibling to a mortgage 
insurer? As long as they are separately capitalized entities, 
we think that is the right way to do those things. Merging the 
loan-level mortgage insurance exposure with the security-level 
bond exposure into a singly capitalized entity or, as Sandeep 
said, having that entity also be exposed to other kinds of 
insurance risks clearly is not going to accomplish what you 
want to accomplish here. We think the monoline requirement is a 
very important aspect of ensuring that capital is brought into 
these entities for the express purpose of funding mortgages 
through the very long cycle, and you want to keep the capital 
within those entities dedicated to that task.
    Senator Warner. And we do envision the FMIC would be 
playing, again, a very important role in conjunction with your 
State insurers to make sure that gets----
    Mr. Durant. Absolutely. As the ultimate counterparty, they 
are the ones who are saying, look, we are the ones holding the 
bag for you guys, you----
    Senator Warner. My time is about up. Let me make one other 
point. I just want to follow up on something that Senator Crapo 
raised in his line of questioning, which was how do we make 
sure--and, again, Mr. Palmer and Ms. Davis, you may want to 
comment on this. If we are going--we all recognize--and one of 
the things we have tried to build in as a transition time a 
ramp-up period so that we can get more of this private capital 
in place, and how we can ensure that we do not put unnecessary 
regulatory, accounting, or other burdens to make this 
transition. We have talked about the concern that some of the 
entities had about registration with CFTC. I know there are 
some concerns in terms of tax treatment around REITs. I know 
there are also accounting issues.
    One of the things I would ask for the record would be 
whether from the experience you have had in the transactions so 
far and looking forward as you expand that universe, what are 
those items that we could perhaps look at to minimize the flow 
of private capital coming in to play this very, very important 
role in terms of protecting the taxpayer. And, again, with the 
discretion of the Chair, if they would let them answer that 
question, then I will be finished.
    Mr. Palmer. Yes, first, we would love to be able to work 
with you and your staff on these issues. I think we definitely 
have learned a lot over the last 2 years, and I think as we 
continue to grow and expand these programs, I anticipate that 
we will continue to learn more and that we can help articulate 
better some of these issues that should be addressed.
    Senator Warner. Thank you, Mr. Chairman.
    Chairman Johnson. Thank you again to all of our witnesses 
for being here with us today and helping the Committee better 
understand the options for increasing private capital's role in 
the housing finance system.
    Chairman Johnson. This hearing is adjourned.
    [Whereupon, at 3:45 p.m., the hearing was adjourned.]
    [Prepared statements, responses to written questions, and 
additional material supplied for the record follow:]
                   PREPARED STATEMENT OF KEVIN PALMER
 Vice President, Strategic Credit Costing and Structuring, Freddie Mac
                           December 10, 2013
    Chairman Johnson, Ranking Member Crapo, and Members of the 
Committee, thank you for inviting me to appear today. I am Kevin 
Palmer, Vice President of Strategic Credit Costing and Structuring at 
Freddie Mac. I head the business unit with primary responsibility for 
the development and execution of the credit risk sharing transactions 
that are the subject of today's hearing.
    In my statement, I summarize the risk-sharing transactions we have 
undertaken to date, discuss the lessons we have learned from these 
transactions, and outline our future risk sharing plans.
    I would like to highlight three points from my statement that I 
believe will be useful as you consider these issues:

    First, we have been very encouraged by strong investor 
        interest in our credit risk sharing offerings to date. However, 
        it is important to note that conditions today are highly 
        favorable for investment in mortgage credit risk. We have seen 
        from recent history that investors can and will leave the 
        mortgage market when conditions are less favorable. So I 
        caution that it will take some time to determine the level of 
        long-term sustainable investor interest in mortgage credit risk 
        sharing, particularly during market and economic downturns.

    Second, we have encountered a number of regulatory, tax and 
        accounting issues that have either affected investor interest 
        in participating in our credit risk sharing transactions or 
        influenced our choices of particular structures for those 
        transactions. We believe Congress should consider these and 
        other similar issues as it determines the role that credit risk 
        sharing instruments can play in any future housing finance 
        system.

    Finally, we designed our credit risk sharing transactions 
        to ensure they are cost effective and preserve forward markets.
Freddie Mac's Progress Under Conservatorship
    The Freddie Mac of today is not the company that existed prior to 
conservatorship. We have a new management team, including new chief 
executive officer, chief financial officer, general counsel, chief risk 
officer, chief compliance officer, chief administrative officer, head 
of human resources, and chief information officer. In addition, we have 
a new head of every business line: single-family, multifamily and 
investments. Most of these leaders are new to Freddie Mac, while a few 
are in new roles since conservatorship. At the same time, we have 
retained many employees with significant experience in and knowledge of 
the mortgage finance industry.
    Freddie Mac is highly mindful and appreciative of the taxpayer 
support we have received. We are focused on using this support wisely 
and effectively to provide liquidity to the home mortgage market, help 
at-risk borrowers avoid foreclosures, and fulfill the objectives of the 
conservatorship. Let me offer a few examples:
    We helped more than 11 million families buy, refinance, or rent a 
home since 2009: Our mortgage purchases enabled 7.5 million families to 
refinance into lower interest rate home mortgages. For loans we 
refinanced during 2013, families are saving an average of $3,400 per 
year. We also funded home purchases for 1.9 million families and rental 
housing for 1.5 million families.
    We helped 913,000 at-risk families avoid foreclosure since 2009: By 
preventing avoidable foreclosures, we not only help at-risk families 
but also stabilize and revitalize neighborhoods. More than 475,000 of 
these families received loan modifications, saving each family an 
average of $5,220 per year. We also are implementing a Federal Housing 
Finance Agency (FHFA) directive to substantially improve how servicers 
work with delinquent borrowers.
    We implemented stronger credit standards, resulting in a 
significantly improved book of business: Our focus is on helping 
borrowers own homes that they can afford and keep. As of September 30, 
2013, mortgages we purchased after 2008 comprise 73 percent of our 
single-family credit guarantee book of business but only 8.6 percent of 
our credit losses. Even with our preconservatorship book of business, 
Freddie Mac's single-family serious delinquency rate--2.58 percent as 
of September 30--is less than half the mortgage industry average of 
5.88 percent (as of June 30).
    By the end of 2013, we will have paid $71.345 billion in dividends 
to taxpayers: This slightly exceeds the $71.336 billion in U.S. 
Treasury funds we have drawn to date. As explained in our November 7, 
2013, financial release, Freddie Mac's payment of dividends does not 
reduce the balance of prior draws of Treasury funds received, and 
Treasury retains a liquidation preference of $72.3 billion on Freddie 
Mac's senior preferred stock.
    We could not have achieved these results without the support we 
have received from FHFA, Treasury and the American taxpayer. But these 
results also attest to the hard work, commitment, and expertise of our 
employees.
Credit Risk Sharing Initiatives
    Freddie Mac began analyzing mortgage credit risk sharing structures 
in early 2011 as a way of removing some of the risk on our books. This 
included studying both the economics and the operational issues 
involved in various risk transfer options and structures. This work 
helped prepare us for FHFA's directives in its 2012 and 2013 scorecards 
to begin undertaking credit risk sharing transactions. The 2013 
scorecard set a target for us to undertake transactions involving 
single-family mortgages with at least $30 billion in unpaid principal 
balances. FHFA specified that we must conduct multiple types of risk 
sharing transactions to meet this target. Such transactions could 
include expanded mortgage insurance, credit-linked securities, senior/
subordinated securities, and other structures. In addition to reducing 
our credit risk exposure, the risk sharing goal is also intended to 
bring more private capital into the market and demonstrate the 
viability of multiple types of risk transfer transactions involving 
single-family mortgages.
    Freddie Mac has undertaken three such transactions during 2013. Our 
first transaction, announced in July, was an offering of Structured 
Agency Credit Risk (STACR) Debt Notes. We just settled a second STACR 
offering on November 12. Also on November 12, we entered into a 
reinsurance transaction. The aggregate unpaid principal balances of the 
mortgages involved in these three transactions will include more than 
$30 billion that we believe qualifies toward FHFA's scorecard.
    Common to these three transactions are several objectives:

    Reduce Freddie Mac's, and therefore taxpayers', exposure to 
        the credit risk of our mortgage purchases by transferring a 
        portion of that risk to private investors.

    Bring new credit investors into the mortgage market.

    Create products that are scalable and sustainable over 
        time.

    Preserve the cost efficiencies of a forward market.
STACR Debt Notes
    STACR Debt Notes allow Freddie Mac to transfer credit risk from 
recently acquired single-family mortgages to credit investors who 
invest in the notes. Interest and principal payments to investors are 
determined by the delinquency and principal payment experience on that 
group of newly guaranteed mortgages, known as a reference pool. 
Although structured as debt notes that are unsecured general 
obligations issued by Freddie Mac, the transaction is similar to a 
credit linked note, which allows us to take advantage of the cost 
efficiencies of the TBA market.
    We structured STACR Debt Notes to attract investors by providing a 
large and highly diversified pool of loans in the reference pool. 
Diversification is attractive to credit risk investors because it 
reduces idiosyncratic risk stemming from concentration in specific 
geographical areas, in originator quality, and servicer practices. The 
reference pools for the first two offerings together included more than 
200,000 high-quality loans, which are diversified based on 
geographical, originator, servicer, and other risk factors, 
representing more than $50 billion in unpaid principal balance. These 
pools consist of a subset of 30-year fixed-rate single-family mortgages 
acquired by Freddie Mac in two recent quarters. Most other securities 
that transfer mortgage credit risk, by comparison, are based on a 
smaller pool of mortgages, generally less than 1,000 loans.
    Freddie Mac remains the master servicer in the STACR transactions, 
retaining control of the servicing of the loans in the reference pools. 
This is beneficial because the loans will be subject to Freddie Mac 
servicing guidelines, allowing us to maintain our strong loss 
mitigation support to borrowers. The structure provides for a defined 
loss transaction--when a borrower is 180-days delinquent (behind by 6 
months) the bond holder takes the defined loss. The structure also 
allows Freddie Mac to manage the assets of the pool after 180 days. 
Freddie Mac retains some risk exposure (at least 5 percent of the 
losses), assuring investors of our aligned interests. This ``skin-in-
the-game'' is important for servicing and loss mitigation control. To 
further demonstrate our alignment of interest, Freddie Mac also 
retained the first-loss risk position in the two STACR offerings. 
Retaining that first-loss position helped investors get comfortable 
with this new type of credit risk sharing instrument, and helped make 
the structure more economically attractive.
    Our first two STACR offerings received positive market responses. 
About 50 broadly diversified investors participated in each offering, 
including mutual funds, hedge funds, REITs, pension funds, banks, 
insurance companies, and credit unions.


    Additionally, our STACR transactions had little or no impact on the 
TBA market. The TBA market provides the means for lenders to sell 
conforming loans into the secondary market before they are originated. 
This enables lenders to better manage the risks of 30-year fixed-rate 
loans and allows borrowers to lock in mortgage rates up to 90 days in 
advance of closing.
What We Have Learned From Our STACR Offerings
    Based on our initial STACR offerings, we can identify several 
issues and challenges:
    Limits to investor appetite: While our initial offerings received 
positive market responses, this does not guarantee that future 
offerings will receive equal levels of investor interest. Investor 
appetite for a particular asset class at any given time depends on a 
variety of factors, including broad economic and market conditions and 
returns offered by other asset classes. Our first two STACR offerings 
took place during very favorable conditions for investing in mortgage 
credit risk. For example, house prices are generally appreciating and 
credit quality is high by historical standards. As we have seen from 
recent history, investors will leave the mortgage market when risks and 
returns are less favorable. While we believe we are well on the road to 
creating an attractive and scalable investment product, it will take 
some time to determine the level of long-term sustainable investor 
interest in STACR Debt Notes as an asset class, particularly during 
market and economic downturns.
    Credit ratings: Our first transaction was not rated by a rating 
agency. In the course of structuring it, we found investors had 
differing views over the need for a rating. In the end, we decided 
against obtaining a rating because doing so would have slowed our 
ability to complete two transactions this year. This somewhat limited 
investor participation and impacted the pricing on the first 
transaction. In the second transaction, one of the two tranches was 
rated Investment Grade by Moody's and Fitch. The pricing on this 
transaction was substantially improved. While we attribute most of this 
improvement to greater market acceptance and familiarity with STACR 
Debt Notes, obtaining a credit rating also helped.
    Tax treatment: Current tax laws affect investor interest in STACR 
transactions. Real Estate Investment Trusts (REITs), for example, must 
primarily invest in real estate assets, including interests in 
mortgages. Because the STACR transactions were general obligation debt 
issuances and not secured by interests in mortgages or real estate 
assets, they did not qualify as real estate assets for REIT purposes. 
While STACR Debt Notes could be held by REITs, there are restrictions 
on the amounts. Also, Real Estate Mortgage Investment Conduits (REMICs) 
cannot hold STACR Debt Notes as collateral because the notes are not 
secured by real property or interests in mortgages and are not 
interests in mortgages secured by real property.
    Accounting treatment: Investors in STACR Debt Notes will mark their 
investments to market under accounting rules, and this will discourage 
some investment in them. Some large investors, such as insurance 
companies, are not interested in assets that are marked-to-market 
because this would create additional income statement volatility. 
Freddie Mac also faces increased income statement volatility from mark-
to-market treatment of our STACR issuances.
    Regulatory hurdles: A Commodity Futures Trading Commission (CFTC) 
regulation played a role in our decision to structure STACR Debt Notes 
as an unsecured general obligation instead of a credit linked note. 
That regulation requires Freddie Mac to register with the CFTC as a 
Commodity Pool Operator and a Commodity Trading Advisor or to seek a no 
action letter from CFTC in order for us to issue credit linked notes. 
Registering with the CFTC likely would have required us to create a 
subsidiary company--a complicated matter given our being in 
conservatorship. Further, if we were to seek a no action letter as 
issuer, our understanding is that some investors would be required to 
register with the CFTC or require a no action letter in order to 
purchase credit linked notes we would issue. CFTC's rule did not 
anticipate this type of offering, and changes to the rule would help. 
In the meantime, Freddie Mac, in concert with FHFA, continues to work 
with CFTC to ensure our full compliance.
    Our experiences with these tax, accounting and regulatory issues 
suggest that policy makers, in the course of legislating housing 
finance reform, should carefully consider how these and other similar 
issues can affect the ability and willingness of private investors to 
assume mortgage credit risk.
    Despite these challenges, we believe Freddie Mac's STACR 
transactions to date have met our objectives and help us meet FHFA's 
scorecard objectives for 2013.
Reinsurance Transaction
    Freddie Mac announced on November 12 that we had entered into a 
reinsurance-based credit risk sharing transaction. We obtained an 
insurance policy underwritten by Arch Reinsurance Ltd. to cover up to 
$77.4 million of credit losses for a portion of the credit risk Freddie 
Mac retained from the reference pool in the first STACR transaction. 
The transaction with Arch enabled both parties to leverage this 
reference pool, and the associated disclosures and due diligence.
    This new insurance coverage is intended to attract new sources of 
private capital from nonmortgage guaranty insurers and reinsurers 
interested in assuming a portion of the credit risk on specified 
portions of our single-family mortgage loan portfolio. Reinsurance 
companies are large diversified companies that specialize in managing a 
variety of risks. Freddie Mac regards reinsurance companies as a 
promising new source of capital for mortgage credit risk transfer.
    Our experience with conducting this first reinsurance transaction 
has led us to conclude that there is interest at this time for U.S. 
mortgage credit exposure among the reinsurance community. Accordingly, 
we see potential to build a risk sharing product targeted at 
reinsurance companies that meets our objectives of transferring credit 
risk, bringing new investors into the market, creating repeatable and 
scalable products, and preserving the cost efficiencies of the TBA 
market. Of course, the level of long-term sustainable interest by 
reinsurance companies in mortgage credit risk sharing transactions, 
particularly during market and economic downturns, remains to be seen.


Risk Sharing Plans Going Forward
    In addition to conducting additional STACR and reinsurance 
transactions, we are looking at two other options for credit risk 
transfer. The first is risk retention by mortgage originators who sell 
mortgages to us through recourse agreements. The key challenge to 
recourse transactions is that sellers retain these obligations on their 
balance sheets. This has regulatory capital consequences for regulated 
financial institutions.
    A second option we are exploring is a senior-subordinate 
securitization. While doing this type of securitization would not allow 
for TBA securitization on these loans under current rules, this 
structure is common, particularly for jumbo and other nonconforming 
loans.
Conclusion
    As Congress determines the future structure of the housing finance 
system, Freddie Mac will remain focused on providing liquidity to the 
home mortgage market, helping at-risk borrowers avoid foreclosures and 
protecting taxpayers' investment in the company. This includes working 
with FHFA to develop new and innovative approaches and products to 
transfer credit risk from taxpayers to private investors.
    Thank you again for this opportunity to appear today.
                                 ______
                                 
                   PREPARED STATEMENT OF LAUREL DAVIS
          Vice President for Credit Risk Transfer, Fannie Mae
                           December 10, 2013
    Chairman Johnson, Ranking Member Crapo, and Members of the Senate 
Banking Committee, thank you for the opportunity to testify today. My 
name is Laurel Davis and I am the Vice President for Credit Risk 
Transfer at Fannie Mae.
    I appreciate the opportunity to share with the Committee 
information on the credit risk transfer transactions that Fannie Mae 
conducted this year. My testimony today will address how those 
transactions were structured and brought to market and the results of 
the transactions.
Background
    Before I address the specific transactions, I think it would be 
helpful to provide additional background on how Fannie Mae manages 
credit risk, the credit risk that we currently hold and how we have 
sought to reduce this risk substantially during conservatorship. This 
is important because what we learned from these particular transactions 
was that investors are willing to purchase mezzanine credit risk on a 
high quality pool of loans if they receive a yield that meets their 
investment targets and where the credit is actively managed by an 
intermediary.
    In order to assess the risk they were purchasing, potential 
investors in our Connecticut Avenue Securities transaction (C-Deal) and 
our counterparty in the mortgage insurance (MI) transaction received 
significant information about our credit policies, our monitoring of 
lender operations, their exposure to the sellers' representations and 
warranties, and our reviews of loan origination quality. Investor 
comfort with our processes and our ability to enforce representations 
and warranties facilitated the investor demand in the transactions. 
While this testimony will not address our servicing standards and 
oversight of servicers, those factors play a strong role in reducing 
our risk of loss and are important considerations for investors 
evaluating the credit risk on Fannie Mae loans.
    Because we accept the credit risk on securities we guarantee, we 
have a rigorous process for managing this risk. We do so through both 
the pricing of loans based on the risk such loans entail and the 
establishment of underwriting standards that lenders with whom we do 
business must follow. Our Selling Guide, which is extensive, is our 
legal contract with lenders. It sets forth the underwriting standards 
to which lenders are required to adhere.
    Our standards are not static. We revise them continuously based on 
our analysis of the performance and quality of our acquisitions and our 
existing book of loans, changes in market conditions and new issues 
that might arise. We also review the loan origination processes of our 
lender customers to ensure that their controls are working properly. 
During conservatorship, Fannie Mae has made numerous changes to our 
analysis of credit risk and to our underwriting and eligibility 
requirements to reduce our credit risk. Some of the significant changes 
include:

    Creating external tools and internal risk models to improve 
        assessment of collateral value;

    Creating a process and risk models to assess the quality of 
        new loan acquisitions, track defect rates and enforce 
        contractual rights soon after delivery to mitigate risk;

    Standardizing our credit policy by eliminating most 
        negotiated credit terms with specific lenders;

    Tightening our underwriting and eligibility requirements 
        for higher risk products, including interest only loans and 
        adjustable-rate mortgage loans;

    Implementing a minimum credit score of 620; and

    Eliminating contract terms that would allow delivery of 
        Alt-A loans or other reduced-documentation loans.

    As a result of our efforts, and improvements in market conditions, 
our serious delinquency rate has fallen dramatically (see Illustration 
A). This rate peaked in February 2010 at 5.59 percent and has since 
fallen to 2.55 percent as of the end of the Q3 of this year. Even at 
its highest point, our serious delinquency rate was substantially lower 
than loans in private label securities or held on bank balance sheets.
    In addition, the loans we have acquired since 2009 have performed 
well. The serious delinquency rate for loans acquired since January 
2009 is 0.32 percent. These new, well-performing loans now make up 
approximately 75 percent of our total book of business.
    The performance of these loans and improving conditions in the 
housing market are two of the primary reasons for our recent financial 
performance. We have recorded seven straight quarters of profit and, as 
of December 31, we will have paid almost $114 billion in dividends to 
the Treasury Department versus total draws of approximately $116 
billion.


Credit Risk Sharing Transactions
    Our credit risk sharing initiatives are aimed at reducing our 
retained credit risk, thereby reducing our footprint in the mortgage 
market and providing a way for greater private investment in mortgage 
credit risk.
    It should be noted that Fannie Mae's Charter requires that there be 
private risk ahead of Fannie Mae's guarantee for high loan to value 
(LTV) ratio loans or loans with less than 20-percent downpayment. This 
has not changed during conservatorship. For all loans with LTV ratios 
greater than 80 percent, our charter requires that Fannie Mae seek 
credit enhancement. This is predominantly done through the required 
purchase of mortgage insurance through regulated insurers capitalized 
by private capital. Our standard coverage requirements, however, 
require greater protection than just the first 20 percent of the 
property value. Loans with LTVs in excess of 80 percent generally have 
coverage that protects the company down to 68 percent to 75 percent of 
the loan amount.
    With that background, I would like to turn now to the two 
transactions we conducted this year to transfer additional credit risk 
to other market participants--our C-Deal transaction and our mortgage 
insurance risk transfer deal. The transactions have a few key 
similarities. First, in both transactions, Fannie Mae retained a first-
loss credit risk position vis-a-vis investors, while selling mezzanine 
risk to investors to cover ``unexpected losses'' after that first-loss 
risk piece is exhausted. Mezzanine risk is located between the first 
loss and the top loss risk levels. For both transactions, the first-
loss piece we retained covered at least 2 times what we modeled as our 
expected losses on the loans underlying the transactions. Fannie Mae 
also retained the risk of catastrophic loss, which was sized at greater 
than what was experienced during the recent housing crisis.
    Second, both transactions were aided substantially by the fact that 
an intermediary stood between investors and originators, in this case, 
Fannie Mae. Investors did not need to underwrite the credit themselves, 
ensure that the underlying loans are properly serviced or make certain 
that representations and warranties with originators are enforced. In 
these particular transactions, this intermediary role allowed the 77 
investors involved in our credit-risk note transaction to rely on 
Fannie Mae's credit policies, underwriting standards, lender oversight 
requirements, and servicing standards rather than understanding the 
standards of more than 1000 lenders with whom we do business. Moreover, 
Fannie Mae serves as an ongoing and active credit risk manager on 
behalf of itself and the investors.
    While we have purchased pool mortgage insurance policies for two 
decades, the C-Deal transaction was a successful first attempt to 
transfer portions of our credit risk to private securities investors. 
We intend to engage in additional transactions to learn more about 
investor appetite for credit risk.
    These two transactions were positive first steps in transferring 
credit risk, but it is early in the process and therefore difficult to 
extrapolate the extent to which broad investor demand exists for 
securities with residential mortgage credit risk or what yield might be 
required.
Connecticut Avenue Securities (C-Deals)
    On October 15, 2013, Fannie Mae priced its inaugural credit-risk 
note transaction under its Connecticut Avenue Securities series, also 
known as C-Deals. This first transaction settled on October 24, 2013.
    Fannie Mae's C-Deals were structured to meet certain program goals:

    First, to provide an additional avenue to manage the credit 
        risk of our guaranty business, in addition to our active 
        management of credit risk as discussed above;

    Second, to create a program that is sustainable and 
        scalable for Fannie Mae;

    Third, to explore the most cost efficient means for 
        transferring credit risk;

    Fourth, to not interfere with how lenders currently sell 
        loans into the secondary market;

    Finally, to have no impact on how a loan is serviced.

    Loans included in this risk sharing transaction will be serviced in 
the same manner as all other loans in our book. Servicers have no 
knowledge of which loans are in a C-Deal reference pools and which are 
not.
    By design, Fannie Mae's C-Deal is structured very similarly to 
Freddie Mac's two STACR offerings, the first of which closed in July 
and the second in November. There are slight differences between Fannie 
and Freddie's deals. Some differences were due to the response to 
market feedback, and others were due to how Fannie Mae evaluated the 
cost/benefit trade-off of particular deal features.
    The C-Deal notes are debt issuances of Fannie Mae. One of the main 
differences between C-deal series debt and Fannie Mae's standard debt 
is that investors in C-Deals may experience a full or partial loss of 
their initial principal investment, depending upon the credit 
performance of the mortgage loans in the related reference pool. 
Another difference is that the repayment of C-Deal notes is tied to the 
credit and prepayment performance of a reference pool of loans. The 
reference pool for our first transaction included approximately 112,000 
single-family loans with an outstanding unpaid principal balance of $27 
billion, which represented about 12 percent of our total acquisitions 
for Q3 2012.
    To arrive at the pool, we applied certain selection criteria to the 
entire population of loans acquired in Q3 2012 to create an eligible 
population of loans. For a loan to be included, it had to be: (1) a 30-
year fixed-rate mortgage; (2) not a HARP loan; (3) with an LTV between 
60-80 percent; and (4) current in terms of payments since acquisition. 
From the eligible population, we used a random selection process to 
derive the reference pool. By only referencing the loans, they remain 
in the MBS pools, thereby avoiding any disruption to the TBA market.
    If the loans in the reference pool experience credit defaults, the 
investors in the C-Deals may bear losses. Credit defaults occur in the 
C-Deal when a loan in the reference pool reaches 180 days of 
delinquency, a short sale, a third party sale, a deed-in-lieu, or an 
REO (Real Estate Owned) disposition occurs prior to 180 days of 
delinquency.
    In the first transaction, Fannie Mae retained the first-loss 
position and holds both the catastrophic risk and a vertical slice of 
the transaction (see Illustration B). The first-loss piece of the 
structure is intended to cover a multiple of our expected losses on the 
underlying loans. We decided to hold the first-loss piece for a number 
of reasons. First, any securities that represented a first-loss 
position may not have been considered ``debt'' for tax purposes and 
could carry significant tax consequences to potential investors. 
Second, given that this was a new program, we believed that retaining 
the first loss would make the transaction easier for investors to 
understand, model and price. Lastly, it was unclear if private 
investors would be willing to purchase the first-loss position at 
pricing that made economic sense for Fannie Mae. However, Fannie Mae 
may choose to sell the first loss in subsequent transactions if the 
economics are appropriate and the associated regulatory issues are 
resolved.
    In addition, we sold two classes of mezzanine risk to the market in 
order to shed the risk of unexpected losses on the underlying loans. 
Fannie Mae retained the catastrophic piece in the structure, which is a 
multiple of a stress scenario based on the recent financial crisis 
experience. Finally, we kept a roughly 6-percent vertical slice of the 
mezzanine risk sold to the market. This was done to align our interests 
with investors and give them confidence that we will diligently service 
the loans in the reference pool so as to limit losses to both investors 
and Fannie Mae.


    The mezzanine risk that we sold was comprised of $675 million of 
notes split evenly between a senior and junior class. The senior class 
of notes, otherwise known as M-1 notes in the marketplace, received an 
investment grade rating of BBB- from Fitch Rating Agency. These notes 
were priced at 1-month LIBOR + 200 basis points. The investment grade 
rating on the M-1 notes opened up investor participation to a wider 
variety of accounts, and we believe this will help promote secondary 
market liquidity.
    The junior class of notes, otherwise known as M-2 notes in the 
marketplace, priced at 1-month LIBOR + 525 basis points. Fannie Mae did 
not pursue a rating on the M-2 notes. We did not receive strong 
feedback from investors that a rating on the M-2 notes would be 
particularly important. Both notes were issued with 10-year final 
maturities.
    A diverse group of 77 investors participated in the offering, 
including asset managers, mutual funds, pension funds, hedge funds, 
insurance companies, banks and Real Estate Investment Trusts (REITs).
    Fannie Mae has disclosed details of our credit risk sharing 
activities on our Web site at fanniemae.com. Loan level data, such as 
interest rate, LTV and original debt to income ratio, was provided on 
the reference pool as part of the initial disclosure. This loan level 
data, as well as ongoing performance on the transaction, will be 
updated monthly.
    We considered other transaction structures, including a senior-
subordinate cash transaction, or ``cash senior/sub'', and a credit-
linked note transaction. As it relates to a cash senior/sub, we closely 
examined the use of this structure to transfer credit risk. In a cash 
senior/sub structure, loans must be deposited into a trust and 
therefore could not be in TBA securities. There are several reasons why 
we decided not to pursue this structure. First, compared to the 
structure we used, the cost of doing a cash senior/sub transaction 
would have been greater. Second, a cash senior/sub structure could 
present scalability issues. In a cash senior/sub structure, the loans 
themselves are sold and thus there is a transfer of both interest rate 
and credit risk. By contrast, in a credit-risk note structure, only 
credit risk is sold, since the interest rate risk was previously 
conveyed in the TBA markets. Accordingly, if Fannie Mae had used a cash 
senior/sub structure to transfer credit risk for the same amount of 
loans as occurred in the first transaction, we would have had to sell 
$27 billion of securities backed by mortgage loans, as compared to 
selling only $675 million in credit securities, given that the loans 
had already been funded through the MBS market. Lastly, a cash senior/
sub structure could introduce a number of operational inefficiencies 
for lenders compared to how they now conduct business.
    With a credit-linked note structure, there are a variety of 
outstanding regulatory issues. As alluded to in the press, these issues 
include the impact of Commodity Futures Trading Commission (CFTC) 
regulations and whether Fannie Mae and investors would need to register 
with, and be regulated by, the CFTC. In addition, there are certain 
issues under proposed conflicts of interest rules being considered by 
the Securities and Exchange Commission, as well as potential tax issues 
for certain investors under Internal Revenue Service regulations. These 
regulatory concerns, and potentially other issues, will need to be 
resolved prior to this type of structure being a viable option.
    We gained several insights from the C-Deal transaction. First, as 
noted above, in this particular transaction, having an intermediary 
that served as an active credit manager was important to potential C-
Deal investors. Our comprehensive approach to credit risk management 
helped to build market reception for the C-Deals well before the 
transactions took place.
    Second, it is essential to be transparent and provide detailed 
information to investors. The rollout and launch of the C-Deals were 
designed to provide transparency to the marketplace on our requirements 
and processes. Over the course of 2 years, Fannie Mae held extensive 
discussions with investors and engaged in a road show to assess the 
market appetite and structure preferences. It was also critical that we 
provided historical loan-level credit performance data to investors on 
over 18 million loans acquired by Fannie Mae over the past 10 years so 
that investors could make their own assessment of expected loan 
performance.
    Lastly, we learned that in these particular market conditions, 
investors will buy mezzanine risk on a high quality pool of loans if 
they receive a yield that meets their investment targets.
    It is too early in the process to reach further conclusions from 
these transactions. Fannie Mae's next transaction is tentatively 
scheduled for January 2014. This will be a debt issuance deal that 
references a pool of loans and will be very similar to Fannie Mae's 
October deal. The reference pool will be comprised of single-family 
loans acquired in Q4 2012 with the same criteria used in our first 
deal.
Mortgage Insurance (MI) Risk Transfer Deal
    After a competitive bidding process, Fannie Mae entered into a 
transaction with National Mortgage Insurance Corporation (``National 
MI'' or ``NMI'') to provide credit risk coverage on over $5 billion in 
single-family mortgages. The agreement was reached on July 15, 2013, 
and coverage went into effect September 1, 2013.
    The MI risk transfer deal covers 2 percent of the loans acquired by 
Fannie Mae in Q4 2012, each of which had an original LTV of 70-80 
percent. These loans were not HARP refinances nor had any credit 
enhancements. None of these loans were covered by mortgage insurance 
prior to the commitment with NMI.
    The coverage was provided in the form of a ``pool insurance'' 
policy, a form of insurance that we have utilized since the mid-1990s, 
to enhance the credit of certain segments of our acquisitions. The pool 
insurance policy that we negotiated with NMI will result in Fannie 
Mae's loan-level exposure on the covered loans being reduced to 
approximately 50 percent of the original property value, subject to a 
pool deductible amount and an aggregate pool loss limit, as explained 
below. The pool insurance policy sunsets after 10 years.
    Similar to the C-Deal transaction, Fannie Mae will be responsible 
for the first losses on the pool. We are insuring for ``unexpected 
losses'' through the establishment of an aggregate pool deductible. The 
deductible was set at 20 basis points of the initial balance of the 
pool, or approximately $10.3 million of initial losses for which Fannie 
Mae will be responsible.
    The insurance policy will cover the next $90 million of claimable 
losses. The aggregate pool loss limit was set to 2 percent of the 
initial balance of the pool. At an approximate $5.17 billion initial 
pool balance, the aggregate pool loss limit is approximately $103 
million, including the deductible layer. Thus, once aggregate claimable 
losses on the pool of loans exceed approximately $103 million, the 
policy would terminate. Fannie Mae would be responsible for losses in 
excess of the pool loss limit. The aggregate pool loss limit was set to 
a level that exceeds our projected losses in a stress scenario 
comparable to the recent experience (2006-2012).
    This pool insurance credit enhancement has several advantageous 
features. First, it will preserve the ability for lenders and Fannie 
Mae to pool mortgage loans into a highly liquid TBA market. This will 
enable the current efficient origination process, allow borrowers to 
lock financing in advance and lenders to hedge that interest rate risk, 
and lower mortgage rates for borrowers because of the liquidity of this 
TBA market. A second advantage is that the mortgage insurance policy 
form for the transaction preserves Fannie Mae's ability to pursue all 
appropriate and needed loss mitigation which Fannie Mae deems 
acceptable, e.g., loan modifications and short sales. Thus, servicers 
follow standard Fannie Mae servicing protocols and service these loans 
as they would other loans, irrespective of the credit enhancement.
    We solicited insurance bids from seven MI companies, which are 
currently approved by Fannie Mae to provide charter-compliant coverage 
for loans that we acquire. In addition to the terms of the pool policy 
structure, we stipulated that MI companies participating in these 
transactions would need to meet certain counterparty requirements, 
including a minimum level of statutory capital relative to their 
outstanding risk in force. Six of the MI companies provided insurance 
bids in response to our request. Only three of those MI companies would 
have met the transaction counterparty requirements without needing to 
raise additional capital.
    We chose to commit the transaction to NMI for several reasons. NMI 
had the materially lowest pricing of all six bidding MI companies, 
agreed to cover all loans in the targeted pool, met our counterparty 
capital requirements, and agreed to the terms of the new pool policy 
form that we requested, including coverage certainty provisions that 
provide for rescission relief.
    One key observation was that although this coverage structure could 
be repeated in the future, the mortgage insurance industry is currently 
capital constrained. Pricing might need to rise considerably in 
connection with possible future transactions, unless the MI industry is 
able to raise new capital.
    In conclusion, I appreciate this opportunity to present testimony 
before the Committee and look forward to answering any questions you 
may have.
                    PREPARED STATEMENT OF TED DURANT
   Vice President of Analytic Services, Mortgage Guaranty Insurance 
                              Corporation
                           December 10, 2013
MGIC History
    Originally formed in 1957 by Milwaukee real estate attorney Max 
Karl, MGIC was established to provide an innovative, affordable 
alternative for families wanting to buy a home with less than a 20-
percent downpayment. In 1965 MGIC became the Nation's first publicly 
traded mortgage insurer. Throughout its history MGIC has been at the 
center of what has evolved into today's highly efficient secondary 
market. In addition to providing mortgage insurance, MGIC created the 
Nation's first private secondary market facility that brought buyers 
and sellers together, was the first to insure mortgage backed pass-
through securities, and was the first to form a conventional mortgage 
securities conduit. In 1971, MGIC created the first modern bond 
insurance company. With a focus on sustainable home ownership, MGIC has 
grown to provide a critical component of our country's residential 
mortgage finance system, protecting mortgage lenders and investors from 
credit losses.
The Roles of Mortgage Insurance and Bond Insurance in a New Housing 
        Finance System
    We believe that, having survived the recent housing finance crisis 
and saved taxpayers from $40 billion of additional losses, the private 
mortgage insurance model has proven its value and should be a 
fundamental component of a new housing finance system. The definition 
of an Eligible Mortgage in S.1217 recognizes the benefits of loan-level 
credit enhancement by requiring minimum coverage levels for low 
downpayment loans. However, mortgage insurers can provide an important 
additional role with the provision of pool-level mortgage insurance.
    The role of bond insurer is different but is also an important 
component of the new housing finance system. Bond insurance was adapted 
for use in mortgage-backed securities (MBS) from the municipal bond 
market. Importantly, bond insurers do not, like the GSEs, purchase and 
aggregate loans for securitization. The role of the bond insurer is to 
guarantee timely payment of principal and interest to the bondholders 
in the event of failure of the issuer. In order to provide this 
guaranty, bond insurers require that the risk of the issuer failing be 
remote. Bond guarantors generally paid insufficient attention to loan-
level credit enhancement on the MBS they guaranteed leading up to the 
housing crisis. Consequently, most of them failed. Nevertheless, the 
role of guaranteeing timely payment of principal and interest is an 
important one and, with the first-loss risk sufficiently transferred to 
other entities, the bond guarantor model can work.
    The new housing finance system envisioned in S.1217 can be improved 
by:

  1.  Clarifying the distinction between mortgage insurance and bond 
        insurance, allowing for both loan-level and pool-level mortgage 
        insurance, and limiting bond insurance to its traditional role 
        of guaranteeing timely payment of principal and interest to 
        bondholders in the event of failure of the issuer, relying on 
        other, first-loss credit enhancement to ensure that the bond 
        guarantor is in a remote risk position.

  2.  Recognizing the loss absorbing resources of mortgage insurers in 
        the calculation of private capital at risk in front of the 
        FMIC.

  3.  Establishing a preference for entities over securities as a means 
        of ensuring a stable supply of capital through the cycle, and 
        relying more on existing regulators of those entities as a 
        means of clarifying the role of FMIC and avoiding a single 
        point of regulatory failure.

  4.  Clarifying the point of attachment of the Government guaranty, 
        and taking into consideration the application of the guaranty 
        to all forms of credit enhancement.

  5.  Broadening the bill to include comprehensive housing finance 
        reform that establishes consistent, uniform rules that apply 
        regardless of the source of funding for the loans.
Would the Bond Guarantor Business Be Attractive?
    With those recommended improvements in place, we expect that there 
will be interest from investors, including companies who write mortgage 
insurance, to capitalize bond guarantors. However, we expect that the 
insurance would be provided by separately capitalized and regulated 
companies who might be jointly owned within a holding company 
structure. In serving very different purposes, mortgage insurance and 
bond insurance should be viewed as complementary, not competing forms 
of mortgage credit risk enhancement. Nevertheless, they should be 
managed, capitalized, and regulated separately.
    The GSEs combined mortgage insurance, bond insurance, mortgage 
aggregation, and securitization into two excessively powerful entities. 
As a consequence they were both our largest beneficiaries and our 
largest competitors. We would be hesitant about competing against 
entities that are renamed GSEs, who are chartered to provide a 
combination of mortgage insurance and bond insurance. With years of 
data and experience as de facto regulators of the MI companies, and 
currently being in the process of determining new eligibility 
requirements for MI companies, rehabilitated GSEs set up to be mortgage 
insurers would have an insurmountable advantage over existing or other 
new mortgage insurers. Setting up the former GSEs as bond insurers 
would likely limit investor appetite for creating competition in that 
business. A healthy housing finance system that minimizes cost to the 
consumers will require many bond guarantors and many mortgage insurers.
Attachment of the Government Guaranty
    S.1217 creates two different ways in which the FMIC guaranty could 
be triggered. In the case of structured finance, such as a senior/
subordinate structure, the guaranty would be triggered by the failure 
of any individual security reaching the subordination level of losses. 
In the case of a bond guarantor, the guaranty would be triggered by 
failure of the entity.
    Individual securities will be backed by a limited number of loans, 
possibly all from the same lender and concentrated geographically. They 
will certainly be originated within a narrow window of time. Thus, 
individual securities will have a great deal of variation in their 
performance, and their likelihood of reaching the 10-percent level will 
be much greater than a collection of those securities. Using a vintage-
level loss trigger eliminates some of the potential lender and 
geographic risk, but still has a higher likelihood of reaching the 
trigger level than a collection of securities issued over many years. 
As the point of attachment gets farther away from individual 
securities, the attachment level needed to provide the same level of 
protection to taxpayers decreases.
    In general, the higher the attachment level, the greater the amount 
of private capital that will be required and, consequently, the higher 
the fees will need to be to provide the private sector guaranty. This, 
of course, translates directly to higher costs to the borrower. 
However, our appetite for participation as mortgage insurers or bond 
guarantors depends not so much on the level of attachment as it does 
the equality of the attachment level and capital requirements among all 
competing forms of mortgage finance. A requirement for a 10-percent 
subordination level for individual securities and a 10-percent capital 
level for bond guarantors would make the bond guaranty business 
uncompetitive until the next housing crisis, when investors in 
subordinate tranches will again abandon the market.
Regulation of Bond Guarantors and Mortgage Insurers
    Bond guarantors and mortgage insurers, being engaged in insurance 
activities, are regulated by the States. Regulation of bond insurers or 
mortgage insurers by FMIC raises significant State-Federal questions, 
adds further complexity to the management of FMIC, and concentrates 
oversight in a single point of failure.
    We believe there are strong arguments in favor of maintaining the 
existing system of State regulation and Federal oversight. Aside from 
the political challenges of changing the State-Federal landscape with 
respect to insurance, there are good reasons to separate the 
responsibilities of regulation and prudential oversight from the 
responsibilities of counterparty risk management. In the housing 
finance system envisioned by S.1217, the bond guarantors would hold the 
counterparty risk of the mortgage insurers, and FMIC would hold the 
counterparty risk of the bond guarantors. Thus, FMIC is the ultimate 
counterparty for both bond guarantors and mortgage insurers. As such, 
it makes sense for FMIC to be responsible for issuing eligibility 
requirements and monitoring compliance. Giving them full authority for 
approval and prudential regulation, however, concentrates too much 
responsibility in one entity that may have conflicting priorities. The 
recent financial crisis demonstrated the importance of having multiple 
points of oversight of mortgage insurers, with the majority of 
companies surviving and continuing to fully pay valid claims.
Considerations for Choosing Risk Transfer Tools
Higher Risk Loans Require Loan-Level Guarantees
    A fundamental principle in selecting a form of risk transfer is 
that, the higher the level of the risk of the loans, the closer the 
risk transfer should be to the loan level. Any loan with a significant 
level of risk of loss should require loan-level credit enhancement 
placed at origination by an entity that is involved in the 
underwriting, origination, and servicing of the loan.
    Safe loans, to borrowers with substantial downpayments and income, 
steady jobs, and strong credit histories, do not require much 
individual attention. There is very little credit risk to transfer and 
the entities that acquire the risk can safely do so after the 
origination of those loans. This lower risk segment of lending is where 
pool MI and bond insurance are appropriate. This is also the segment in 
which Fannie Mae and Freddie Mac have undertaken their recent credit 
risk transfer transactions.
    However, as the level of risk increases, it becomes progressively 
more important to pay attention to the quality of underwriting and 
verification of the offsetting factors that will help a borrower 
overcome weak points in their qualifications. Entities that take the 
credit risk on these loans must participate in and make their credit 
decisions during the underwriting and origination process. This is a 
distinguishing feature of loan-level private MI and an important source 
of protection for the U.S. taxpayer. The use of subordinated tranches 
and security-level guarantees for the securitization of subprime 
mortgages, for example, produced disastrous results. The guarantors and 
the investors in the bonds were too isolated from the underwriting and 
origination of the loans to understand and manage the true risk they 
presented. Loan-level mortgage insurance has been proven to reduce the 
default risk on high LTV loans, demonstrating its effectiveness and 
justifying its longstanding inclusion in bank capital requirements, GSE 
charter requirements, QRM statutory language, and the S.1217 definition 
of Eligible Mortgage.
Differentiation Must Be Maintained Between Mortgage Insurance and Bond 
        Insurance
    Bond insurance and mortgage insurance serve two different purposes. 
Mortgage insurance covers losses to the lender in the event a borrower 
defaults. Bond insurance covers timely payment of principal and 
interest to bond investors in the event an issuer defaults. The 
guaranty of timely principal and interest requires substantial, 
immediate liquidity in the event of an issuer default, so bond insurers 
rely on other forms of credit enhancement to ensure that the likelihood 
of a claim is remote. Mortgage insurance, on the other hand, involves 
frequent claims at the loan level, but the time between borrower 
default and the resolution of the claim is substantial (usually well 
over a year), so liquidity is not as important as overall capital. 
Those are different business models that require separately capitalized 
entities for proper risk management.
    Importantly, bond insurers should be kept in a remote risk position 
through a combination of loan attributes and additional credit 
enhancement. As long as that is the case, bond insurance and mortgage 
insurance should be thought of as complementary, not competing, forms 
of credit enhancement.
Entity-Based Enhancement Is More Stable Than Security-Based Enhancement
    Another fundamental goal of housing finance reform should be to 
ensure the proper supply of capital for mortgages through the economic 
cycle. People like to refer to two states of the world--``Normal'' and 
``Stress'' (See, for example, the presentation by James Stock to the 
Urban Institute 11/13/13, available at http://www.urban.org/
UploadedPDF/412947-Cyclical-Stabilization-and-the-Structure-of-
Mortgage-Finance.pdf). From the perspective of a mortgage insurance 
company, the period 2003-2007 is not normal, and we should not be 
trying to get ourselves back to that state. If there is going to be 
Government intervention in mortgage markets, the purpose must be both 
to ensure sufficient liquidity in a stress and to prevent excessive 
liquidity in ``normal'' times. This is only feasible if mortgage credit 
risk is managed by entities that dedicate their capital, both human and 
financial, to being in business through the cycle. The illusion of a 
``best execution'' cost advantage of structured transactions is, in 
reality, the mechanism that creates the boom-bust cycle, providing too 
much credit in a boom, and no credit in a bust. Entities in the 
business of creating structured transactions are motivated to make the 
next deal, creating a very short-term focus on transaction volume. 
Insurers, in contrast, are motivated to build and maintain a book of 
insurance in force that is sized to the amount of capital they have 
available. This capital level does not change quickly, creating a 
significantly more stable level of funding capacity through the cycle.
Capital Requirements Must Relate Consistently to Risk Absorbed
    While it is important for there to be a number of tools available 
for mortgage credit risk transfer, it is also important for regulators 
to ensure that capital treatment across the tools is consistent with 
the risks they bear and the benefits they bring. It is a deceptively 
simple matter to calculate the amount of ``private sector capital'' in 
a senior/subordinate securitization structure. The level of 
subordination marks a clear dividing point, and the subordinated bonds 
represent true cash available to absorb losses at the initiation of the 
transaction. In practice, the level of subordination can be highly 
affected by prepayments. Complicated interest maintenance mechanisms 
have to be in place to ensure the sufficiency of the subordination 
level as the security is paid down. Shifting prepaid principal can 
significantly alter the prepayment characteristics and, consequently, 
the valuation of the senior bonds.
    The equivalent protection offered by insurers is best measured as 
loss absorbing capacity, which includes capital, reserves, and premium. 
Capital and reserves are readily converted to an equivalent of cash. 
While the forecast of premium is subject to some uncertainty, in 
practice the forces that cause increased losses also generally cause 
increased premium (also known as guarantee fees) through longer loan 
lives. Projection of premiums and, thus, the calculation of how much 
loss absorbing capacity is provided by an insurer should be the kind of 
task easily performed by a competent regulator.
    In addition to correctly calculating the capital requirements for 
each form of risk transfer, it is vitally important that all of the 
loss absorbing capacity be included in the calculation of private 
capital at risk in front of the taxpayers. As written, S.1217 does not 
appear to allow for credit for mortgage insurance, for example, to be 
included in the calculation of whether there is 10-percent capital. The 
result will be a significant understatement of the private capital at 
risk. This will increase borrowing costs and create the disincentive 
for use of anything other than minimal levels of MI, regardless of the 
actual economics and amount of risk transferred.
Incentives and Moral Hazard
    The phrase ``skin in the game'' is overused, but it describes an 
important aspect of designing a sound housing finance systems. All the 
participants must have some incentive to properly manage risk. Insurers 
employ a variety of tools to manage the risk of moral hazard, in which 
insurance beneficiaries have the incentive to behave in such a way as 
to increase the risk to the insurer. Deductibles and coinsurance are 
two commonly used tools. In mortgage insurance, limited depth of 
coverage on primary loan-level insurance provides servicers with the 
incentive to take proper care of delinquent borrowers and minimize the 
loss severity on defaulting loans. Risk transfer tools should always be 
designed to ensure that the potential for moral hazard is explicitly 
managed. Retention of some amount of risk is frequently and 
appropriately used to accomplish that.
Accounting True Sale and Consolidation
    Discussion of risk retention in mortgage securitization must also 
include consideration of the accounting issues of true sale and 
consolidation. One of the primary values of securitization is to create 
a source of funding that allows the lender to remove the loans from 
their balance sheet. This occurs when the securitization transaction is 
considered to be a true sale of the loans to the securitization entity. 
Accounting rules, specifically FAS 166 and 167, describe the 
circumstances under which a true sale of the loans has occurred, and 
whether the loans must be consolidated back to the lender's balance 
sheet even if it is considered a true sale. While moral hazard 
considerations make it desirable for lenders to retain risk, true sale 
and consolidation issues could cause those risk retention features to 
make the mechanism unusable. Critical factors for ensuring the 
securitization successfully transfers the risk include control of the 
underwriting criteria, control of the servicing, beneficial interest in 
the securities, and exposure to risk. In Ginnie Mae securitization, the 
control of underwriting and servicing criteria by the insurers (FHA, 
VA, RHS) and the position of the Government as the ultimate bearer of 
risk make the Federal Government the consolidating entity, despite the 
fact that the lenders, as Ginnie Mae issuer/servicers, retain a portion 
of the risk. In GSE securitization, there is no question that a lender 
selling a loan to the GSE constitutes a true sale and there is no 
consolidation risk back to the lender. However, as private entities, 
the GSEs should have to consolidate all the loans underlying their 
guaranteed bonds back to their balance sheets. Under S.1217, it is not 
yet clear whether the system envisioned would result in the Government 
being the consolidating entity, or whether private entities would have 
to consolidate. The resolution of that question will have a significant 
impact on the feasibility of the system.
Background: The Fundamentals of Mortgage Risk
    Mortgage loans are secured lending, meaning that the borrower has 
pledged her ownership of her house as collateral in case she is unable 
(or unwilling) to repay the loan. The risk to the lender, then, is 
determined by both the likelihood of the borrower failing to make her 
payments and, should that happen, the risk that the value of the 
property will not be sufficient to pay off the remaining debt. The 
likelihood of the borrower failing to pay off the loan is referred to 
as default incidence by insurers and probability of default (PD) by 
bankers. The amount that the lender loses, which is the difference 
between the remaining debt and the value of the property, is referred 
to as loss severity by insurers and loss given default (LGD) by 
bankers.
    Default incidence is driven by borrower circumstances, including 
the amount of equity the borrower has in the property. When the 
borrower purchases the home, the amount of equity is the downpayment. 
Over time, the property may gain or lose value, the borrower may pay 
down the loan, or refinance for a greater amount (cash out), or take 
out a second mortgage. All of those events change the borrower's equity 
in the home. If a borrower takes out additional financing and the home 
loses value, the borrower may find himself in a position of negative 
equity, also referred to as being underwater. A borrower with negative 
equity, who might otherwise be able to afford to make his mortgage 
payments, might choose to stop making those payments, in what is called 
a strategic default. Under normal market conditions, most borrowers 
default because of adverse changes in their personal circumstances, 
such as job loss, death or disablement, or divorce.
    Loss severity is driven by the amount that can be recovered by 
selling the property, relative to the outstanding debt. In addition, 
expenses associated with foreclosure, including legal fees, accrued 
interest, and real estate maintenance and sale expenses, increase loss 
severity. The longer it takes to complete the process, the greater the 
loss severity. This results both from the increased expenses and 
interest, and the deterioration of the property as homes in foreclosure 
are typically not maintained properly.
    Loss mitigation is the reduction of loss severity through a variety 
of actions by the loan servicer to, first, keep the borrower in the 
home and, second, minimize the amount of time it takes to resolve the 
default. Keeping the borrower in the home often results in an improved 
outcome for the lender. Techniques for doing this include forbearance, 
in which some amount of the debt is delayed in repayment, and 
modification, in which the term of the loan may be extended, the 
interest rate reduced, or some portion of the debt forgiven. Another 
loss mitigation approach is a short sale, in which the borrower and 
lender agree to sell the property for a loss, and the lender then 
either forgives the remaining debt or the borrower may agree to pay off 
some portion of the remaining debt as an unsecured loan.
    Fraud and misrepresentation are an additional risk in mortgage 
lending that became more widely recognized in the recent financial 
crisis. They are more accurately described as operational risk, not 
credit risk, but they have a significant impact on credit risk. 
Mortgage lenders, investors, and insurers all rely on representations 
and warranties (reps and warrants) from other entities as to the truth 
of the information on a mortgage application. Borrowers make 
representations to lenders. Lenders make reps and warrants to investors 
and insurers. Misrepresentation of facts, either unintentionally or 
fraudulently, may significantly alter the credit risk of a mortgage 
loan. For example, if a borrower makes $40,000 per year and the 
application shows $480,000 per year, the borrower will have a 
substantially greater likelihood of default than what would be expected 
from the application. Note that this mistake could have occurred 
because (a) the borrower lied, (b) the lender changed the information 
without the borrower's knowledge, or (c) an annual income amount was 
accidentally treated as monthly and multiplied by 12.
    The consequences of fraud and misrepresentation have been 
widespread, particularly in loans originated from 2005-2008. Mortgage 
insurers that found material fraud and intentional misrepresentation 
have rescinded coverage, meaning they canceled the coverage and 
returned all premiums paid, refusing to pay insurance claims on those 
loans. Mortgage investors like Freddie Mac and Fannie Mae have required 
lenders to repurchase billions of dollars of loans. Financial 
guarantors, having paid significant claim losses on guaranteed pools, 
have sued and obtained billions of dollars in recoveries from issuers. 
FHA has recovered billions of dollars from their lenders through 
indemnification requests and through Government fraud suits involving 
treble damages.
First-Loss Exposure and the Credit Risk Stack
    First-loss exposure is a significant concept in secured lending. 
Most defaults involve a recovery of some amount from sale of the 
property or continued payment of the modified loan by the borrower. 
Someone in a first-loss position takes losses regardless of how much is 
recovered, assuming the recovery is not sufficient to pay off the whole 
loan. For example, if a loan has a balance of $100,000, and the lender 
recovers $70,000 from the sale of the home, the loss is $30,000. If the 
lender has mortgage insurance that covers the first 25 percent of 
losses, the insurer pays the first 25 percent x $100,000 = $25,000, 
leaving the lender with the remaining $5,000 of loss. The remaining 
loss is referred to as residual risk after the first-loss position.
    Importantly, the first dollar of loss is more at risk than the next 
dollar. This follows from the uncertainty of how much will be recovered 
from the sale of the property, and the fact that each additional dollar 
of recovery is less likely. Put another way, the first dollar of loss 
will almost certainly be lost in a default, but the last dollar will 
almost certainly be recovered.
    This concept illustrates why downpayment is such an important 
consideration in mortgage lending. The borrower's downpayment 
represents the true first-loss position in the transaction. Losses to 
the lender (and any insurers) only come after the borrower's equity is 
used up. Greater borrower equity directly lowers the expected severity 
in the event of default. And, as discussed earlier, greater borrower 
equity, all else equal, lowers the likelihood of default, as well.
    The credit stack is often used to illustrate the exposure to loss, 
as shown in Figure 1. The various entities exposed to risk are shown in 
a vertical stack, with the first-loss position at the bottom, and more 
remote positions toward the top. If the borrower has equity, they may 
be shown at the bottom. In this example, the borrower makes a 10-
percent downpayment, the mortgage insurer covers 25 percent of the loan 
amount, and the investor (Freddie or Fannie) has the residual risk. The 
amount covered by the mortgage insurer is referred to as the depth of 
coverage. The farther you get from the bottom of the stack, the more 
remote is your risk.


    Structured securitization involves a similar concept, but it 
operates on a pool of loans, rather than an individual loan. In a 
senior-subordinate securitization, the monthly loan payments flow 
through a waterfall, in which the senior bondholders are paid first and 
the subordinate bondholders receive any remaining payments. In this 
case, the subordinated holders bear 100 percent of the severity of each 
loss, up to the point at which they have lost their remaining 
principal. At that point, the senior bondholders begin bearing 100 
percent of the severity of each loss. Figure 2 shows a securitization 
credit stack, which typically does not include the borrower equity. In 
the example, there is a 10-percent subordination level, in which two 
subordinate bonds equal 10 percent of the total debt and senior bonds 
equal 90 percent of the total debt. Just as in the case of the 
individual loan, the higher you go in the stack, the more remote the 
likelihood of a loss.


Forms of Mortgage Credit Risk Transfer
    Mortgage credit risk transfer is typically done in two ways, 
through entities and through structured transactions. These two are not 
mutually exclusive, and in private securitization often both have been 
used. Entity-based forms of risk transfer include mortgage insurance, 
financial guaranty (bond insurance), and reinsurance. Structured 
transactions include surplus notes, senior/subordinated (tranched) 
securitization, and synthetic derivatives.
Entity-Based Forms of Credit Risk Transfer
    Mortgage Insurance can be provided by Government insurers (FHA, VA, 
RHS, PIH, Housing Finance Agencies) and by private mortgage insurers. 
Mortgage insurance typically covers individual loans, though it may 
also be used on pools of loans. Mortgage insurance is almost always in 
a first-loss position or is used in combination with other mortgage 
insurance that is in a first-loss position. Mortgage insurers control 
their risk on loan-level insurance through limited depth of coverage, 
which limits the severity risk but not the incidence risk. In other 
words, the depth of coverage limits the losses on any individual loan, 
but does not limit the number of loans on which losses may be paid. 
Losses paid on one loan do not reduce the insurer's obligation to cover 
the remaining loans. Pool insurance typically reverses that, covering 
100 percent of the losses on each loan, but limiting the total losses 
and, therefore, the total incidence. Once the coverage limit has been 
reached, remaining loans are uncovered.
    Standard private insurance coverage depth today is 30 percent for 
loans with a 5-percent downpayment, 25 percent for loans with 10 
percent, and 12 percent for loans with 15 percent. FHA insurance covers 
100 percent of the losses, although their interest reimbursement 
typically does not cover all of the accrued interest advanced by the 
servicer. VA insurance generally covers 25 percent. RHS insurance 
generally covers 90 percent.
    Mortgage insurance generally requires that the servicer acquire 
title to the property through foreclosure or complete a short sale in 
order to file a claim. The insurer then adjusts the claim to ensure the 
expenses are appropriate and the loss is calculated properly. The 
insurer also may investigate the loan documents for evidence of fraud 
or misrepresentation. After the insurer has made any required 
adjustments and assuming they do not find fraud or misrepresentation, 
they pay the servicer.
    Financial Guaranty (Bond Insurance) can be provided by Government 
entities (Ginnie Mae, for example) or private financial guaranty firms. 
Private bond insurers, like mortgage insurers, are regulated by State 
insurance departments. Bond insurance is distinguished from mortgage 
insurance in that: it always operates at the pool level, never at the 
loan level; it is always placed in conjunction with a securitization 
transaction; it generally operates at a zero expected loss level, i.e., 
a remote level in which some other form of risk transfer is in the 
first-loss position; and it covers the risk of default by the issuer of 
the mortgage-backed security, not by the individual borrowers. Because 
of that last factor, bond insurers begin making payments to bondholders 
immediately on default of the issuer. If the bond insurer later finds 
material fraud and misrepresentation, they must sue the issuer to 
recover those losses. Bond insurance generally does not have any limit 
on losses. This combination of features makes it very important that 
bond insurers place their guarantees on pools of loans that are very 
safe or sufficiently credit enhanced to make the bond insurer's risk 
very remote.
    Reinsurance can be provided by Government entities (e.g., TRIA for 
terrorism risk, FCIC for crop insurance) or by private insurers. In the 
private sector, there are global firms that specialize in providing 
reinsurance across a variety of sectors and risks. They seek to 
diversify across uncorrelated risks, so that their likelihood of facing 
claims on multiple exposures at the same time is minimized. Like 
financial guarantors, reinsurers generally operate at remote layers of 
risk, with some other entity (typically the entity they are reinsuring) 
taking the first-loss position. Government reinsurance is typically 
used to cover true catastrophic risk such as terrorist attacks, floods, 
or crop failure.
    Mortgage insurers and financial guarantors have similar regulatory 
rules that are different from other forms of insurance and from other 
forms of mortgage banking. The primary feature of their regulation is 
the capital and contingency reserve requirement. Each company must hold 
a minimum amount of capital, relative to the risk insured. In addition 
to that capital and case based reserves, which are specific reserves 
for delinquent loans, the company must hold a contingency reserve. The 
contingency reserve requirement is typically to hold 50 percent of 
earned premiums for a period of 10 years. Funds may only be released 
from the reserve in the event that losses exceed a significant level. 
As a result, mortgage insurers and bond insurers have a unique 
countercyclical capital requirement, forcing them to accumulate claims 
paying resources in excess of their minimum capital requirement during 
profitable periods, which may be drawn upon during periods of 
significant stress.
    Claims paying resources, or loss absorbing resources for an insurer 
are the sum of their capital, their reserves (including the contingency 
reserve), and the premium they receive from coverage renewal. These 
resources form the ``private capital at risk'' when a mortgage insurer 
covers a loan.
Structured Forms of Risk Transfer
    Surplus Notes are a type of debt used by insurance companies to 
transfer risk to the debt holders. They typically involve a variable 
rate of interest that depends on the loss performance of the insured 
risk. As losses to the insurer increase, the payments to the surplus 
note holders decrease, offsetting the losses to the insurer.
    Senior/Subordinate (Tranched) Securitization, as described earlier, 
strips risk from the underlying loans and transfers most of that risk 
to the subordinate bondholders, leaving the senior bondholders in a 
more risk-remote position. Like pool insurance, once the subordinate 
layer is used up, the remaining loans are no longer protected.
    Synthetic derivatives transfer risk to investors through securities 
whose performance depends on the performance of a reference pool of 
loans. They are similar to surplus notes, in that they feature debt 
securities that provide a variable rate of return based on the 
performance of the reference pool. There is not an exact correlation 
between actual losses and the performance of the pool, however. Recent 
examples of this approach, like the Freddie Mac STACR transaction, 
transfer losses to the investors at a fixed severity level when loans 
reach a specified level of delinquency. As a result, investors are 
insulated from the consequences, both positive and negative, of loss 
mitigation and loss severity risk.
                                 ______
                                 
                  PREPARED STATEMENT OF SANDEEP BORDIA
  Head of Residential and Commercial Credit Strategy Barclay's Capital
                           December 10, 2013
    Good Morning, Chairman Johnson, Ranking Member Crapo, and other 
Members of the Committee. My name is Sandeep Bordia and I am the head 
of residential and commercial credit strategy at Barclays in New York. 
My group covers research on mortgage credit markets in the U.S. and 
Europe, including research on housing finance. I appreciate the 
opportunity to discuss the fundamentals of transferring credit risk 
from the U.S. taxpayer to the private markets.
    In my remarks, I will start by describing the STACR and CAS credit-
linked deals (Freddie Mac and Fannie Mae risk-transfer deals), 
including what has worked for these structures and what can be improved 
going forward. I will also talk about the buyer base, the market's 
appetite to absorb such issuance and how that would change if the 
attachment point of the Government guarantee is higher. Finally, I will 
compare and contrast the credit-linked note approach to two other 
proposed structures: (a) the senior-sub structure; and (b) the bond 
guarantor approach.
STACR/CAS Deals Overview
    To begin with, let me talk briefly about the STACR/CAS deals 
recently sold by the GSEs. So far, three deals have been priced, two 
from Freddie Mac and one from Fannie Mae (for a total of $1.8 billion 
in credit issuance). In each of these deals, the GSEs have retained the 
risk on a 0.3-percent first-loss position and sold the credit risk on 
the 0.3- percent to 3-percent loss piece. This means that the GSEs will 
absorb losses on the first 0.3 percent of notional on the underlying 
reference pool of loans for these transactions. Further, at the risk of 
oversimplifying, the buyers of the issued securities will absorb losses 
to the extent that they range from 0.3 percent to 3 percent of the 
notional. In each case, the GSEs have also retained some small amount 
of this 0.3-percent to 3-percent slice of risk while retaining the 
right to reduce their ownership to as low as 5 percent by sales in the 
secondary market. Appendix A shows a snapshot of the three deals. The 
0.3-percent to 3-percent risk slice sold is broken into two parts, one 
more senior than the other to better target the risk appetites of 
various classes of investors. In all the three deals, the risk of 
losses above 3 percent is borne by the GSEs and by extension, the 
taxpayer.
    The structures were very well received by the market with all three 
deals oversubscribed many times over. The buyer base was fairly broad 
with several dozen investors participating. Money managers dominated 
purchases of the more senior of the two tranches on offer. Hedge funds, 
money managers and REITs invested in the junior of the two tranches. 
Insurance company involvement was somewhat limited due to uncertainty 
around capital requirements on these tranches under the National 
Association of Insurance Commissioners (NAIC) model-based approach. 
Many investors were comfortable with the credit profiles and also used 
financial leverage to buy these bonds.
What Has Worked for the Credit-Linked Note Structures So Far?
    In our past published research, we have argued that to be 
successful, any solution used to transfer mortgage credit risk to the 
private market should have certain basic features. The solution should 
preserve the well-functioning To-Be-Announced (TBA) market for 
disseminating the interest rate risk on mortgages and allow mortgage 
originators to hedge out their origination pipelines. The solution 
should also be simple (to the extent possible), use existing financial 
technology and be programmatic so as to attract a wide range of 
investors.
    In our opinion, the credit-linked note structure satisfies most of 
these conditions. It allows the preservation of a liquid, well-
functioning TBA market, is simple for market participants to 
understand, uses existing financial technology and is scalable into a 
standardized program.
What Else Needs To Happen for This Program To Be Successful?
    In our view, a few more things need to happen for this program to 
be successful in the long run.

    One, for GSEs (or any new entity) to be able to access a 
        well-functioning liquid credit market on a regular basis, 
        involvement from a broad range of investors is required. Since 
        there are fixed costs for investors to set up internal systems 
        to analyze and track performance of these deals, broader 
        participation requires a programmatic approach to issuance. In 
        other words, investors need to be confident that the deals are 
        not one-offs and the program is here to stay. We would also 
        caution against excessive experimentation with the structures 
        that may create a more fragmented marketplace and reduce 
        liquidity.

    Two, expanding the type of collateral on which the credit 
        risk is sold is critical. The initial deals covered only the 
        cleanest portion of GSE originations that is not fully 
        representative of the collateral quality that GSEs or any such 
        entity would be expected to guarantee over time.

    Three, in the long run, reducing the time between agency 
        MBS issuance and credit-risk transfer would help. The GSEs are 
        effectively warehousing the credit risk during that time 
        period. As such, shortening the window would reduce potential 
        taxpayer exposure. In addition, a shorter time window would 
        also allow for more timely market-based feedback into guarantee 
        fee pricing for future production. It might make sense to sell 
        even the 0-percent to 0.3-percent first-loss tranche as the 
        time between agency MBS issuance and credit-risk transfer 
        shrinks.
Market Appetite To Absorb the Risk
    While the initial three deals have been heavily oversubscribed, the 
amount of credit risk sold so far is miniscule in comparison to what 
the GSEs have on their guarantee books. To put numbers in perspective, 
a 3-percent to 4-percent loss tranche on a $5 trillion book would 
translate into $150-200 billion of credit-linked notes (compared to the 
$1.8 billion that was sold this year). We believe that the market can 
absorb $5 to $10 billion next year without much disruption, and even 
greater numbers in 2015 and later. For the program to get to a stage 
where it can absorb much of the mortgage credit risk with GSEs, it 
would realistically take several years of continued ramp up.
    One big source of potential demand would be investors in legacy 
nonagency MBS. There is currently about $850 billion (face value) 
outstanding in the nonagency market. This is paying down at the rate of 
$60 to $70 billion annually. Given strong mortgage credit expertise 
among many of these investors, some of the paydowns they are receiving 
would likely be reinvested in these securities. We could also see 
additional interest from money managers and REIT-like entities.
What Is the Right Attachment Point for the Government Entity To Absorb 
        Losses?
    Among other things, the attachment point for the Government entity 
to absorb losses is a function of the policy goal and also the 
collateral quality on which the credit risk is being sold. The 
attachment point would be higher if the policy goal is to prevent 
taxpayer losses even in extreme draconian scenarios. A 3-percent 
attachment point might be reasonable for pools where the market expects 
very low losses but would not be enough where base expectations are 
close to or even higher than 3 percent. Generally speaking, a worse 
quality pool of underlying mortgages would require a higher attachment 
point and/or higher risk premiums for the credit-risk-transfer 
securities.
    For example, consider loans originated in Q3 2012, with an average 
loan-to-value of below 80 percent. Since then, home prices have risen 
another 10 percent to 15 percent around the country. As such, the 
current loan-to-value ratio makes these mortgages even safer and a 3-
percent attachment point might be reasonable. In contrast, a 3-percent 
attachment point on newer production with greater LTVs and no 
accumulated home price appreciation might not be enough. This is 
especially so because we learnt through the crisis that in a bad 
economic environment, poor credit quality loans have losses that are 
several multiples of the losses of good quality loans.
How Do We Think About the 10-Percent Tranche Proposed by S.1217?
    As I mentioned earlier, a constant attachment point for all kinds 
of collateral might not be reasonable, in our view. In a scenario where 
we look at a 10-percent first-loss piece, the first thing to consider 
is whether all of this would even be considered as a first-loss piece 
by the market. So, while a 10-percent slice of a $5 trillion market 
would equal $500 billion in mezzanine/subordinate bonds, not all of it 
may be considered as deep credit investments and some may even receive 
high investment-grade credit ratings. In other words, while more 
credit-linked securities would need to be sold in the market, this 
should mean that the buyer base could be expanded from what we have 
seen on the STACR/CAS deals to include more risk-averse money managers 
and insurance companies.
    One number to consider is that, even at its peak, the total amount 
of subordinate and mezzanine bonds outstanding in the nonagency market 
in 2005-2007 was slightly below $400 billion. So, while it is certainly 
possible for the private market to absorb $500 billion in supply, it is 
by no means a done deal and would take a relatively long time to 
achieve.
Other Approaches to Credit Risk Transfer
    There are two other approaches that are being considered for 
transferring credit risk from a Government-supported entity. The first 
is to use a securitization style vehicle in the form of a senior-sub 
structure. The second is to use well-capitalized bond guarantors to 
cover losses.
Senior-Sub Structure Less Preferable
    As we have recommended in the past, we prefer credit-linked notes 
to senior-sub structure as they allow us to preserve the well 
functioning TBA market as is. A senior-sub structure could also 
increase the warehousing costs for originators if they were forced to 
hold both the interest rate and credit risk until they accumulated 
enough loans to issue a senior-sub deal. This could be particularly 
problematic for smaller originators who may have to accumulate loans 
for months before they could do a reasonably sized deal. In theory, it 
would be possible to create a new TBA-like market just for the seniors 
but it might orphan the existing TBA market, would likely be a 
difficult transition and may have lower liquidity than the current set-
up.
Bond Guarantors as Providers of First Loss
    Alternatives to selling credit risk in transactions like STACR/CAS 
include using bond guarantors as providers of first loss. On the 
positive side, this exit solution will likely provide more stable 
funding for mortgage credit than securitization options (credit-linked 
and senior-sub structures). The securitization option is likely to be 
more procyclical, especially because of the availability of leverage to 
investors in buying those securities. However, the bond-guarantor 
structure also has two major drawbacks compared to the STACR/CAS 
structures, in our view.

    First, this form of insurance may result in some 
        counterparty credit risk. The STACR/CAS deals provide the GSEs 
        with cash equal to the face value of the first-loss piece sold. 
        This cash can be set aside to provide the GSEs with an actual 
        cash capital cushion in case losses exceed the threshold that 
        the GSEs have chosen. In the insurance/bond guarantee 
        transaction, the insurer does not have to pay this cash up 
        front but only if losses exceed a certain level. While S.1217 
        requires bond guarantors to hold capital equal to at least 10 
        percent of the guaranteed balance, this only works as a 
        safeguard if the bond guarantors' only business is to provide 
        insurance on these MBS. If the guarantor is involved in other 
        lines of business, unless the capital is held in a separate 
        account for the benefit of the enterprises or their successor, 
        the taxpayer still takes on some counterparty credit risk to 
        the guarantor. For example, if in certain extreme situations, 
        the losses on the guarantors' other lines of business exceed 
        the capital set aside for those business lines, there is some 
        risk that the insurers have to pay out using the capital 
        otherwise required to be held to cover mortgage losses. This 
        could potentially lead to a situation where some part of the 10 
        percent is not covered and the taxpayer is exposed to the risk. 
        Stronger oversight and regulations separating the capital held 
        for guaranteeing MBS could potentially mitigate this risk, but 
        would not eliminate it completely.

    Second, the bond guarantee structures would not be as 
        transparent in pricing as the STACR/CAS deals since there would 
        be no secondary market to provide liquidity/pricing information 
        on an ongoing basis. The secondary market would provide more 
        immediate feedback to guarantee fee pricing than an insurance/
        bond guarantee transaction could. A fully functional secondary 
        market in these credit tranches also provides useful 
        information that could allow a fully private market to price 
        credit risk in a more transparent manner and could help in 
        fostering a fully private market.
Conclusion
    Overall, while we favor the credit-linked structure, given the size 
of credit risk transfer required over the long run, it might be 
preferable to have multiple exit options including through bond 
guarantors. While I believe that there are various paths to achieve the 
goal of transferring credit risk to the private market, I would caution 
policy makers to closely watch the pace of any such transition. The 
availability of mortgage credit remains extremely important to the 
housing market and the economy as a whole and any sudden shocks to the 
system that reduce this availability could have far-reaching 
consequences.
    Chairman Johnson, Ranking Member Crapo, and other Members of the 
Committee, I thank you for your time and attention and the opportunity 
to testify before the Committee.


                   PREPARED STATEMENT OF WANDA DELEO
 Deputy Director, Division of Conservatorship, Federal Housing Finance 
                                 Agency
                           December 10, 2013
    Chairman Johnson, Ranking Member Crapo, and Members of the 
Committee, my name is Wanda DeLeo and I am the Deputy Director of the 
Office of Strategic Initiatives at the Federal Housing Finance Agency 
(FHFA). Thank you for the opportunity to appear before you today to 
discuss the credit risk transfer activities we have asked Fannie Mae 
and Freddie Mac, or the Enterprises as I will refer to them, to 
participate in, particularly securities market sales of credit-linked 
debt instruments. I'd like to start by recognizing the important work 
this Committee has undertaken to redesign the Nation's housing finance 
structure, including specifically the current work of the Chairman and 
Ranking Member, the efforts of Senators Corker and Warner, and those of 
their cosponsors, as well. We remain eager to help in any way we can.
    More than 5 years into conservatorship, the Enterprises continue to 
provide funding for roughly two-thirds of all new mortgages. Combined 
with direct Government guarantees through FHA and VA, this amounts to 
roughly 90 percent of new loans being supported by the Federal 
Government. Enterprise losses since the financial crisis in 2008 
required the Treasury to inject $187.5 billion of capital into those 
companies. While the new loans they insure or guarantee are of much 
higher quality than those that led to most of the losses, it is prudent 
to seek alternative funding mechanisms that place less potential burden 
on taxpayers. Our credit risk transfer program is designed to do 
exactly that.
    Improved housing market conditions, coupled with policy changes and 
strong efforts of staff of both Enterprises to address still serious 
deficiencies in their business operations, have enabled a welcome 
return to profitability. But that should not blind us to the very real 
costs associated with the Enterprises' failures. The dividends they 
have paid to the Treasury reflect not a return of capital, but payment 
for the extraordinary risk the Government was forced to take in view of 
the potential at the time for economic disaster. The current earnings 
are only possible because of the Treasury investment; no one even today 
would be purchasing Enterprise debt in the absence of it.
    It is in keeping with FHFA's responsibilities as conservator to 
minimize taxpayer risks while helping to ensure the secondary mortgage 
market continues to serve its functions. At the same time, we are 
seeking to develop standards, norms, experience, and private investment 
capacities that can continue into the future of a new secondary market 
structure. Credit risk transfers can help us simultaneously in all 
three of our broad conservatorship goals: build, contract, and 
maintain. Accordingly, we have set a target for each of the Enterprises 
to conduct multiple types of risk sharing transactions involving single 
family mortgages with a total of at least $30 billion of unpaid 
principal balances in 2013. We specified that the transactions be 
economically sensible, operationally well-controlled, transparent to 
the marketplace, and involve a meaningful transference of risk. 
Further, we informed the Enterprises that our evaluation for assessing 
their performance on FHFA's conservatorship scorecard objectives will 
also consider the utility of the transactions to furthering the long-
term strategic goal of risk transfer. We will make final judgments 
later this year, but clearly the transactions completed this year have 
accomplished a great deal.
    The Enterprises have initially focused on two broad categories of 
credit risk sharing transactions. One transaction category is prefunded 
capital markets transactions, which include Freddie Mac's Structured 
Agency Credit Risk securities (STACRs) and Fannie Mae's Connecticut 
Avenue Securities (C-deals). In these transactions, investors buy debt 
securities that offer relatively higher returns if the credit 
performance of loans in a reference pool is good, but may lose 
principal when credit performance deteriorates. There is no 
counterparty risk for the Enterprises because when investors buy the 
securities, they are putting up cash that covers their maximum losses. 
This approach offers efficient, competitive, market pricing of risk. It 
also spreads risk across many investors with varying degrees of 
leverage, and with varying degrees of risk concentration in mortgages. 
Less risk concentration and less leverage has the potential to reduce 
systemic risk relative to past and current practices that channel the 
bulk of the risk into a very small number of highly leveraged 
institutions, such as the Enterprises. A possible downside is that 
overreliance on this approach may leave the market for risk more prone 
to price change in response to changing market conditions.
    The other transaction category for this year's Enterprise 
transactions is insurance or guarantee agreements. In these, a mortgage 
insurer, reinsurer, or other guarantor pays claims in the event of 
loss. These deals can take advantage of such firms' mortgage expertise 
and dedicated capital, and they may be less quick to leave the market 
during a temporary market disturbance, especially one not directly 
related to housing markets. However, this approach involves more 
counterparty risk, more vulnerability to housing market weakness when 
the counterparties are not diversified, and a more limited set of 
bidders for the risk.
    In both types of transactions, the Enterprises essentially use a 
portion of their guarantee fee income from the reference pool to 
purchase credit protection, either through higher interest rates paid 
on the capital market transactions, or though premiums paid to 
insurance companies. FHFA worked closely with the Enterprises on each 
of this year's transactions, and in each case was confident that 
conservatorship goals would be served. Reaching this point required 
strong efforts by many over an extended period of time, and I want to 
recognize the excellent work of the staffs of Fannie Mae and Freddie 
Mac, including those sitting beside me today.
2013 Securities Transactions
    This year, each Enterprise has sold debt securities that transfer 
to private investors a portion of the credit risk of a large reference 
pool of single-family mortgages that the Enterprise had previously 
securitized. Freddie Mac has completed two STACR transactions to date, 
and Fannie Mae has completed one C-deal. Each transaction provides 
credit protection to the issuing Enterprise by reducing the principal 
on the debt securities as credit performance of the reference pool 
deteriorates.
    Freddie Mac's transactions occurred in July and earlier this month. 
In the July offering, the Enterprise sold $500 million in STACR notes, 
resulting in credit protection on $18.5 billion of collateral 
consisting of mortgages funded in the third quarter of 2012. In the 
November offering, Freddie Mac sold an additional $630 million in STACR 
notes, resulting in credit protection on $23.3 billion of collateral 
that the Enterprise had funded in the first quarter of 2013. The STACR 
notes are unsecured general obligations of Freddie Mac.
    The credit event that results in losses on the STACR notes is 
determined to occur if a loan becomes 180-days delinquent or there is a 
third-party sale, a short sale, a deed-in-lieu at foreclosure, or a 
sale of real-estate owned (REO) before 180-days delinquency. When such 
a credit event occurs, a credit is calculated based on a tiered loss 
severity schedule, where the severity increases with the cumulative 
unpaid principal balance (UPB) of the underlying loans that experience 
credit events. If calculated credit losses exceed 0.3 percent of the 
UPB of the reference collateral pool, the principal of the STACR notes 
is written down by the amount of the excess, until the calculated 
losses exceed 3 percent and the remaining value of the STACR notes is 
eliminated. In these initial transactions, Freddie Mac retained the 
risk for the first 0.3 percent of UPB and any losses beyond 3 percent 
in large part because of cost effectiveness considerations. Covering a 
wider range of losses may be appropriate in the future.
    In each STACR transaction, Freddie Mac sold notes that provide 
protection on about four-fifths of the underlying loan pool to 
investors, retaining the risk on the balance of the reference pool. The 
Enterprise can elect to seek protection on some of the retained risk, 
but has committed to maintain a minimum 5-percent interest in each 
tranche of each deal. The risk-retention requirement is designed to 
align the interests of Freddie Mac and investors that have bought the 
STACRs.
    The STACR notes have a final maturity of 10 years. With a fixed 
loss severity and final maturity, Freddie Mac is exposed to some basis 
risk on calculated credit losses on the reference pool from 0.3 percent 
to 3 percent. In addition, the Enterprise retains exposure to the first 
0.3 percent of calculated credit losses and to calculated losses beyond 
3 percent.
    In October Fannie Mae issued debt securities with a similar 
structure. Specifically, Fannie Mae sold $675 million worth of 
Connecticut Avenue Securities, resulting in credit protection on $25 
billion of mortgages securitized in the third quarter of 2012. A 
material difference compared to the STACR transactions was in the 
tiered loss severity schedule. Further, one tranche of the Fannie Mae 
security received an investment-grade rating from one credit rating 
agency, and that was also achieved in Freddie Mac's second issue this 
month.
Legal Issues Associated With the Security Structures
    Both the STACRs and C-deal were issued as senior debt of Fannie Mae 
or Freddie Mac. In each case, investors can rely on those Enterprises' 
special credit standing, including the backing of the Treasury through 
the preferred stock purchase agreements, for comfort that the payments 
on the securities to investors will occur as specified in the terms of 
the notes.
    Part of the purpose of these transactions, though, is to develop 
standardized credit risk investments that could be sold in the future 
by securitizers other than the Enterprises. The Enterprises ultimately 
hope to issue credit-linked notes through bankruptcy remote trusts that 
would have the same economics for investors, but a different legal 
structure that would not rely on an Enterprises' credit standing, but 
rather on the trust holding and managing the proceeds from the note 
issuance. Issues that arose include questions about whether issuers or 
purchasers of the trust certificates would be commodity pool operators 
under the Commodity Exchange Act, and whether issuers could be subject 
to the conflict of interest rules under the Securities Act of 1933. We 
are working with other agencies to resolve these questions, but 
statutory clarifications might be helpful, and we are working with 
Committee staff on possible solutions. We would also note that all of 
these structures would be ineligible for REMIC tax treatment because 
they would be considered synthetic structures. If they could obtain 
similar treatment, the investor base for the securities would be 
significantly expanded.
2013 Insurance Transactions
    Both Enterprises have completed insurance transactions this year, 
as well. In October Fannie Mae executed a pool insurance policy with 
National Mortgage Insurance (National MI). The policy transfers a 
substantial portion of the credit risk on a pool of single-family 
mortgages securitized by the Enterprise in the fourth quarter of 2012. 
The aggregate initial UPB of the loans in the pool was nearly $5.2 
billion, and each mortgage had an initial LTV ratio of between 70 
percent and 80 percent. Under the policy, Fannie Mae is responsible for 
actual credit losses on the pool up to 0.2 percent and above 2 percent 
of the initial aggregate UPB. National MI is exposed to credit losses 
above 0.2 percent and less than or equal to 2 percent of the initial 
aggregate UPB, but its exposure on each loan is limited to 50 percent 
of its initial UPB. Thus, the policy has an aggregate loss limit of 
about $103.4 million with a deductible of about $10.3 million. National 
MI will pay claims based on actual credit losses determined after an 
REO sale, short sale, or third-party disposition of the property. To 
limit its counterparty risk, Fannie Mae has required National MI to 
maintain a risk-to-capital ratio not to exceed 15:1 through 2015. 
Thereafter National MI will maintain capital levels required by Fannie 
Mae's then-applicable requirements.
    In November Freddie Mac executed a transaction that transferred to 
Arch Reinsurance, a global reinsurer, a portion of the residual credit 
risk that the Enterprise had retained on the reference pool of 
mortgages underlying the first STACR transaction. Specifically, Freddie 
Mac had retained the credit risk associated with approximately $4.0 
billion (about 18 percent) of the UPB of the reference pool. Under the 
reinsurance transaction, Freddie Mac transferred the risk on $2.9 
billion of that UPB to Arch, leaving the Enterprise with retained risk 
on just over 5 percent of the total UPB, as required by the terms of 
the STACR transaction. Because Arch insures diversified risks, its 
financial health likely is less tightly tied to housing markets and 
mortgage performance, so it may, other things equal, be better able to 
pay mortgage claims in a severe housing stress environment.
Looking Forward
    The Enterprises have executed transactions that transfer single-
family mortgage credit risk to capital-market investors and to firms in 
the insurance industry. Each type of risk-transfer model has inherent 
strengths and weaknesses. From an Enterprise perspective, the sale of 
securities to capital-market investors provides up-front funding of 
credit risk without posing any counterparty risk, while transferring 
credit risk to an insurer leaves an Enterprise exposed to the claims-
paying ability of its counterparty.
    From an overall housing finance system perspective, the leverage of 
participating investors in capital markets transactions may not be 
regulated, so there may be significant variation in the amount of 
equity capital deployed to bear credit risk. Further, capital markets 
funding sources maybe more volatile as a source of funding for mortgage 
credit risk over the credit cycle. Transferring risk to the insurance 
sector could be a more stable source of funding mortgage credit risk 
over the cycle to the extent the financial strength and leverage can be 
closely monitored either by the market or through regulatory 
requirements.
    Potential differences in the leverage of investors under the two 
models also have implications for their relative cost. FHFA and the 
Enterprises will continue to assess those strengths and weaknesses as 
we explore both models of credit-risk transfer in parallel. Pricing on 
all of the transactions this year has been attractive, suggesting that 
each may be scalable to a significant degree. An increased volume of 
issues next year will provide additional information about the depth of 
demand.
    A potentially powerful means of risk transfer is use of senior/
subordinate security structures. While none are expected this year, the 
Enterprises have made progress in considering how such structures might 
best work. In the process, they are grappling with many of the problems 
faced by private label securities issuers of the recent past such as: 
due diligence, representations and warranties, dispute resolution, and 
the role of trustees. This approach has an advantage in that markets 
have a good deal of familiarity with it, but the experience has been 
less than satisfactory in many cases, particularly involving private-
label mortgage-backed securities. If good solutions can be found for 
past problems, this approach may be easier than some others for non-
Enterprise issuers to adopt. A disadvantage to transferring losses on a 
small pool of mortgages in a cash transaction, rather than on a large 
reference pool in a synthetic transaction or insurance agreement, is 
that credit evaluation costs can be considerably higher, as investors 
must consider the idiosyncratic risks of a particular small pool, 
rather than those of a cohort diversified by geography, lender, and 
sheer size. Considering ways to develop more standardization and 
liquidity in this market could help to address some of these issues.
    The transactions considered so far have been Enterprise-centric in 
that they depend heavily on the Enterprises' existing business 
practices and the familiarity of loan sellers and investors with those 
practices. To increase the potential generality of risk-sharing 
approaches and reduce the dependence on the Enterprises, it may be 
useful to explore the potential for loan sellers to arrange for credit 
enhancements, such as those provided by securities or insurance before 
the loans are sent to an Enterprise, rather than leaving it to the 
Enterprise. Similarly, servicing and loss mitigation could possibly be 
outsourced to firms specializing in those activities. Such changes 
would not happen soon or quickly, but they merit consideration over 
time.
Conclusion
    The Enterprises have made major steps in risk transfer this year. 
If sufficiently scalable, these transactions provide mechanisms to free 
taxpayers from shouldering almost all the burden of mortgage credit 
risk and place that risk in the private sector. We will, with the 
Enterprises, continue to explore new techniques or variations on those 
already tried to find the most workable solutions and those that show 
the best promise of reducing the Enterprises' footprint, consistent 
with maintaining efficient and effective mortgage markets. Thank you 
and I am happy to answer any questions you may have.
        RESPONSES TO WRITTEN QUESTIONS OF SENATOR CRAPO
                       FROM LAUREL DAVIS

Q.1. Many witnesses called for providing flexibility to the 
FMIC in permitting different structures for the transfer of 
credit risk. Can you elaborate as to why flexibility needs to 
be provided to guarantors in their transfer of credit risk?

A.1. As the question above states, the issue of flexibility in 
credit risk transfer transactions was raised several times 
during the recent hearing. In responding to that question, I 
was only addressing the desirability to permit flexibility for 
guarantors when structuring particular transactions to transfer 
credit risk to other credit investors. I was not intending to 
address the more general question of whether a statute should 
provide flexibility in how or in what amount private capital 
should be required to attach prior to a Government guarantee.
    As it relates to the need for flexibility for transfers of 
credit risk by guarantors, to the extent that credit risk 
transfer transactions proliferate, there are several reasons 
why different structures may need to be used. They will need to 
be conducted in different market environments, with different 
investor demands that include potentially different pools of 
collateral, and different investor bases (e.g., insurer's, 
REITs, and money managers) which may have different tax, 
regulatory and accounting needs. In order for the transactions 
to be economically efficient for guarantors and attractive to 
potential investors in credit risk, these differences may 
require the creation of transactions with diverse structures 
and will likely require different attachment points. 
Accordingly, if Congress intends to draft legislation that 
either requires or permits guarantors of mortgage credit risk 
to transfer such risk, it would be highly desirable for such 
guarantors to be granted significant flexibility in how they 
structure such transactions.
    Another aspect that should be considered related to 
flexibility is the prevailing regulatory environment in which 
guarantors will operate. Guarantors may need flexibility in how 
they structure transactions to ensure compliance with such 
requirements, including capital regulation. Federal financial 
regulators have already opined on these issues as it relates to 
other financial institutions.
                                ------                                


         RESPONSES TO WRITTEN QUESTIONS OF SENATOR REED
                        FROM WANDA DELEO

Q.1. On what date will the entire Common Securitization 
Platform be ready to perform all of its functions?

A.1. The Enterprises are currently developing the Common 
Securitization Platform (CSP), and have built the core 
functionality and the related infrastructure components. 
Preliminary testing is underway. The CSP's design and its 
development have necessarily evolved over time, and a 
significant amount of work remains with regard to both the CSP 
itself and the business entity that will own it. The 
Enterprises are engaged in developing and implementing 
operational and business processes for the CSP and the joint 
venture entity, and they are developing their integration plans 
critical to the success of the CSP. Fannie Mae and Freddie Mac 
are conducting this work under FHFA's guidance and with 
industry input. Consequently, plans for this project will 
continue to evolve as the Enterprises take into account the 
many factors that will drive project success. The project plans 
will not be finalized until the Enterprises, under FHFA's 
oversight, are in a position to do so. As a result, we do not 
yet have a date by which the Common Securitization Platform 
will be operational.

Q.2. When the Common Securitization Platform is finally ready 
to perform all of its functions, how much money, all in, will 
have been spent in total by FHFA, each GSE, and Common 
Securitization Solutions, LLC, including contracting costs? 
Does this cost include the cost of any adjustments and upgrades 
that may be necessary so that Fannie and Freddie can take 
advantage of the Common Securitization Platform? If not, what 
is this additional cost expected to be?

A.2. As discussed above, the Common Securitization Platform 
project plans, inclusive of the design, build, and testing of 
the technology and the Enterprises' system and process changes, 
are being finalized. As a result, we have neither final plans 
nor specific budgets assigned to these still-in-development 
projects. To date, the following funds have been spent:

    CSP and CSS: $65 million (1/21/2012-12/31/2013)

    Fannie Mae Integration: $20 million (1/1/2013-12/
        31/2013)

    Freddie Mac Integration: $7 million (1/1/2013-12/
        31/2013)

Q.3. FHFA staff has stated that FHFA ``has not prepared a 
formal valuation analysis regarding the platform,'' which I 
find disturbing, especially since taxpayer funds are 
essentially at stake here and are in the process of being 
spent. Should we be worried by the fact that FHFA is making 
financial decisions with taxpayer funds without any ``formal 
valuation analysis regarding the platform?''

A.3. FHFA understands your concern but believes that the 
approach to the project has been prudent and well considered. 
The project is consistent and aligned with many other projects 
undertaken by the Enterprises, at the direction of the agency, 
to achieve uniformity in areas essential to achieving an 
effective mortgage securitization system. The Servicer 
Alignment Initiative, Common Appraisal Data Portal, and Uniform 
Mortgage Data Program are some of the projects that have 
established common and uniform standards and practices in the 
Nation's housing finance system, providing benefits not just to 
the Enterprises, but also to other market participants.
    The decision to engage the Enterprises in this project is 
neither solely nor even principally a financial decision, 
although the financial costs associated with it are very 
important and being monitored. Rather, the decision is rooted 
in FHFA's legal obligations, both as conservator and regulator. 
The decision is based on achieving market efficiencies and 
providing policy makers with options as they determine the 
future of the U.S. housing finance system. The agency has 
determined that the building and operation of the CSP would 
also achieve many supervisory goals and realize other 
significant benefits.

Q.4. Fannie and Freddie are still two distinct legal entities, 
and FHFA acts as conservator for each GSE. Given how valuable 
the Common Securitization Platform would be to each GSE on its 
own, how did FHFA, as conservator for each GSE, determine that 
a 50/50 joint venture was the right decision for each GSE? In 
preserving and conserving the assets of Fannie with a view 
towards putting it in a sound and solvent condition, why would 
FHFA, as conservator for Fannie, give Freddie a 50 percent 
stake in such a valuable asset?

A.4. As Conservator, FHFA decided that it was most beneficial 
to establish common securitization technology, which would be 
available to Fannie Mae and Freddie Mac and ultimately to all 
market participants, rather than have each Enterprise 
separately undertake extensive and proprietary infrastructure 
projects. FHFA believes that building the CSP functionality 
once, through the joint and collaborative efforts of, and its 
use by, both Enterprises, will be more cost-effective than 
having each Enterprise independently rebuild its core 
securitization and servicing systems. Neither of the 
Enterprises' existing systems would allow for relatively quick, 
effective and efficient access by the industry either in the 
near or medium term. Furthermore, independent and proprietary 
Enterprise systems would not allow for uniformity across the 
mortgage finance industry, thereby exacerbating the current 
disarray within the industry and complicating the already 
difficult task before policy makers. FHFA believes that two 
different systems rather than common technology could seriously 
delay or complicate attempts to reform the Nation's housing 
finance system. Independent technology provides policy makers 
with greater options for reforming the system than would a 
rebuilding of the Enterprises' individual systems. FHFA and the 
Enterprises have established a process to ensure that each 
Enterprise's contribution to the joint venture is equitable and 
fair retroactively and prospectively.

Q.5. Please provide all formation documents prepared in 
conjunction with the formation of Common Securitization 
Solutions, LLC (CSS), including but not limited to the 
operating agreement, all legal opinions, all resolutions from 
the Board of Directors for each of Fannie Mae and Freddie Mac 
duly authorizing the formation of CSS, and documentation of all 
costs incurred thus far and expected costs associated with CSS.

A.5. We would be happy to provide you and your staff an 
opportunity to review the documents noted above at the FHFA 
offices. Please contact Peter Brereton, Associate Director for 
Congressional Affairs, if you would like to schedule such a 
review, and if you require additional information or have 
additional questions.
              Additional Material Supplied for the Record
  PREPARED STATEMENT OF LAURIE S. GOODMAN, DIRECTOR, HOUSING FINANCE 
                   POLICY CENTER, THE URBAN INSTITUTE
    Mr. Chairman, Ranking Member Crapo, and Members of the Committee, 
thank you very much for the opportunity to testify today. My name is 
Laurie Goodman, and I am the director of the Housing Finance Policy 
Center at the Urban Institute. This is a new center, dedicated to 
providing data-driven analysis of policy issues relating to housing 
finance and the housing market. Prior to joining the Urban Institute 
this past summer, I spent almost 30 years as a mortgage-backed 
securities research analyst and as head of securitized products 
research/strategy at several firms, including Amherst Securities Group 
LP and UBS.
    Recently, both Freddie Mac and Fannie Mae have completed deals in 
which they transferred some of the risk from their guarantor book of 
business to private investors. As we contemplate a new housing finance 
system in which private entities take the first loss, backed up by a 
catastrophic Government guarantee, the obvious question arises: to what 
extent are these deals applicable to a new housing finance structure?
    The answer is that there are lessons that can be learned from the 
recent transactions, but the lessons are not completely transferable to 
a new structure. This discussion is divided into four sections. The 
first looks at the Freddie and Fannie risk-sharing transactions and 
their impact in the current environment, where efforts are being made 
to reduce the Government footprint. The second section looks at the 
role of risk-sharing type structures in a guarantor/bond insurance 
framework. The third section looks at the role of risk-sharing type 
structures in a capital markets framework. The final section contains 
my conclusions. To quickly preview my conclusions:

    Regulatory relief through changes in the CFTC commodity-
        pool rules is necessary to promote the use of credit-linked 
        notes.

    Capital regulation for future guarantors should include 
        stress tests, a base capital ratio of 5 percent, a risk-based 
        capital component, and capital relief for credit-risk 
        transfers, subject to a minimum absolute capital requirement.

    The system must have a guarantor (insurer) execution and 
        not rely solely on the capital markets to lay off credit risk.
Freddie and Fannie Risk-Sharing Transactions
    In the absence of Government-sponsored enterprise (GSE) reform 
legislation, the Federal Housing Finance Agency (FHFA) has attempted to 
bring private capital back into the mortgage market. They have employed 
a number of mechanisms and have contemplated others. These fit into 
three main categories:

    The FHFA has attempted to decrease the share of 
        originations purchased by the GSEs. They have raised guarantee 
        fees to encourage lenders to use other execution channels, such 
        as holding loans in portfolio or opting for a private-label 
        securitization. Guarantee fees at Fannie Mae have increased 
        from 28 basis points (bps) in the first quarter of 2012 to 58.7 
        bps in the third quarter of 2013, more than a doubling in an 
        18-month period. This has not been sufficient to curb the 
        reliance on the GSEs, but future guarantee-fee increases of 10-
        20 bps could tip the execution of the highest quality loans to 
        bank portfolios, which could, in turn, result in adverse 
        selection to the GSEs. Private-label securitizations are much 
        more expensive than either GSE or bank executions at the 
        present time, and a considerably larger guarantee fee increase 
        would be required for this execution channel to be used. 
        Reducing loan limits is another lever that the FHFA has 
        considered as a way to reduce the GSE share.

    The FHFA has contemplated vehicles that allow for risk 
        transfer at the point of sale (up-front risk sharing). The GSEs 
        would be permitted to accept loans with more credit enhancement 
        in exchange for lower guarantee fees. This can be done though 
        deep mortgage insurance (MI), through lender recourse, or 
        conceptually by allowing the lenders to arrange their own 
        capital markets transactions, similar to the risk sharing deals 
        that have been recently completed by Fannie and Freddie. The 
        Mortgage Bankers Association has proposed greater use of up-
        front risk sharing. \1\
---------------------------------------------------------------------------
     \1\ See, Mortgage Bankers Association ``Key Steps on the Road to a 
Sustainable Secondary Mortgage Market'', 9/18/2013.

    The FHFA has also required Fannie and Freddie to lay off 
        risk that is already on their books (back-end risk sharing). 
        The GSEs have tried three different methods for laying off this 
        risk: (1) capital markets transactions, (2) purchasing mortgage 
        pool insurance, and (3) purchasing reinsurance. Fannie and 
        Freddie have each done deals in which the mortgage credit risk 
        has been laid off via capital markets transactions. There have 
        been three deals to date: Freddie Mac's Structured Agency 
        Credit Risk deals (STACR 2013-DN1 and -DN2), and Fannie Mae's 
        Connecticut Avenue Securities deal (CAS 2013-C01). In August, 
        Fannie Mae announced it had tapped National Mortgage Insurance 
        Corporation to insure a pool of $5 billion of mortgages already 
        on Fannie's books. And in November, Freddie Mac executed a 
        transaction that transferred to Arch Reinsurance, a global 
        reinsurer, a portion of the credit risk that it had retained on 
        the first STACR transaction. The capital markets transactions, 
        and their applicability to the future state, are the focus of 
        this panel, but a few comments on their applicability in the 
---------------------------------------------------------------------------
        current state is also in order.

    Fannie and Freddie's three capital markets risk-sharing 
transactions have been very successful. The first deal was priced too 
cheaply, as one would expect from a new asset class. This, however, had 
the effect of enticing investors who did not participate in the first 
deal to take a look at subsequent structures. Since the first deal, 
there has been a move to tighter spreads as the asset class has gained 
acceptance. For example, the M-2 tranche of the first STACR deal, 
priced in July, sold at 715 bps over 1-month LIBOR, while the second, 
priced on November 12, sold at a 425 bps spread. Table 1 shows details 
for the three transactions, including the spreads at which the 
securities were sold. At this point there is very substantial private-
sector interest, which is critical as policy makers look to the private 
markets to take more mortgage credit risk.
    These risk-sharing transactions, in conjunction with the other 
actions being contemplated and taken, are a very valuable way to 
contract the Government's footprint in the mortgage market while the 
GSEs are in conservatorship. They can be done administratively at the 
direction of the FHFA, and require no legislative action. We expect to 
see many more of these transactions now that both GSEs have established 
programs.
A Few Details on the Risk-Sharing Transactions
    Before we delve into the applicability of these transactions in a 
new, reformed housing finance system, it is important to underscore a 
few specifics about these transactions.
    The transactions are synthetic; that is, they reference the 
relevant credit risk. The transactions are structured as unsecured 
general obligations of Freddie Mac (for the STACR deals) and Fannie Mae 
(for the CAS deal). The return of principal on the notes is tied to the 
credit risk of a pool of residential mortgage loans (the reference 
pool) owned or guaranteed by Freddie Mac (Fannie Mae). Freddie Mac 
(Fannie Mae) is entitled to reduce the principal balance of the notes, 
at a tiered severity percentage, when the loans in the reference pool 
became at least 180-days delinquent or when another credit event 
occurs. This tiered severity ranges from 10 percent to 40 percent in 
the Fannie deal, and 15 percent to 40 percent in the Freddie deals. 
Prepayments are generally passed through to the note holders pro rata 
as a return of principal.
    The deals were done as synthetic transactions because of the desire 
to mimic the credit-risk transfer in a senior/subordinate structure. 
Using an actual senior/subordinated structure would not be economical 
because the senior bonds would not be eligible to trade in the ``to be 
announced'' (TBA) market and thus would lose a considerable amount of 
liquidity.
    The FHFA has publicly stated that they want to expand the types of 
deals being done to include senior/subordinated transactions. These 
types of transactions make sense for collateral that is not eligible 
for delivery into the TBA market. One of the largest buckets of non-TBA 
eligible collateral is pools of jumbo loans, which are priced lower 
than corresponding TBA securities. \2\ I expect there to be a senior/
subordinated transaction backed by jumbo collateral at some point in 
2014.
---------------------------------------------------------------------------
     \2\ Jumbo loans are those over the base GSE limit of $417,000; in 
high-cost areas, where the limit is tied to area median prices, it now 
ranges up to $625,500, and has been as high as $729,750. A de minimus 
amount of these loans can be included in TBA pools; the balance must be 
pooled separately. The collateral for a senior/subordinated deal would 
be composed entirely from the non-TBA eligible jumbo loan pools.
---------------------------------------------------------------------------
    The structures take the form of debt obligations, not credit-linked 
notes. During the first half of 2012, as the planning for the risk 
sharing began, it was expected that the structures would assume the 
form of a credit-linked note with an embedded swap. In a credit-linked 
note, the security is issued by a special purpose company or trust. 
This special purpose vehicle (SPV) takes the initial proceeds of the 
offerings and invests them in a risk-free instrument, such as U.S. 
Government debt. The SPV simultaneously enters into a credit default 
swap; under the terms of the credit default swap, the SPV receives an 
annual fee based on the remaining principal balance, and makes 
payment(s) if credit event(s) occur. Thus, investors will receive the 
interest on the cash investment plus the annual fee. They may receive 
less than a par return on their cash, depending on whether the level of 
credit events was sufficient to impact their principal. A credit-linked 
note structure is a pure bet on the risk being transferred; the credit 
risk of its sponsor is not a factor.
    In September 2012, the CFTC broadened its definition of ``commodity 
pool'' to cover many transactions that include swaps. If the issuance 
had been done as a credit-linked note, it would have fallen under the 
broadened commodity pool definition. Commodity pools are subject to 
reporting and regulatory burdens that I believe are inappropriate for 
an instrument of this nature. For example, a nonexempt pool operator 
must not only register as a Commodity Pool Operator (CPO), but the CPO 
must become a member of the National Futures Association (NFA). Its 
personnel must register with the NFA and pass an NFA exam. There are 
also numerous reporting requirements designed to capture information 
from entities operated for the purpose of trading commodities; it is 
unclear how many of these can be applied to securitizations, which are 
passive vehicles containing illiquid assets. This includes periodic 
reporting concerning the commodity pool's changes in net asset value, 
trading strategies, and performance data. It would also require the 
securitization to name a Commodity Trading Advisor (CTA), and the 
choice of this entity in a securitization is unclear: it could be the 
sponsor or the trustee. The commodity pool registration could trigger 
Volcker Rule prohibitions, making it difficult for banks to own these 
instruments.
    By issuing the obligation as Freddie Mac or Fannie Mae debt, rather 
than from a SPV, these problems were avoided. The only difference 
between doing these transactions as GSE debt rather than as credit-
linked notes is that the investor was exposed to the credit risk of the 
sponsor. The STACR and CAS transactions contain exactly the same 
embedded swap as they would in an SPV structure.
    Investors are happy to buy these transactions as a debt issue 
because they believe Fannie and Freddie are backed by the full faith 
and credit of the U.S. Government, and hence they are making a decision 
solely on mortgage credit risk, rather than a joint decision on the 
mortgage credit risk and the strength of the underlying entity. In a 
market in which the entity laying off the risk was not fully 
Government-backed, the structure used for the STACR and CAS 
transactions would definitely be more expensive, and might not be 
viable. Thus, as we move away from a Fannie/Freddie-dominated world, it 
becomes critical that the CFTC issues some form of regulatory relief so 
these transactions could be done as credit-linked notes.
    The structures reference well-diversified pools of loans. Freddie 
Mac's STACR 2013-DN1 deal (see Table 1) had the smallest reference 
pool, at $22.5 billion. This reference pool included all loans acquired 
by Freddie Mac between July 1, 2012, and September 30, 2012, that met 
the following criteria: (1) full documentation, 30-year fully 
amortizing fixed-rate first-lien loans on one- to four-unit properties; 
(2) originated on or after April 1, 2012, and securitized in Freddie 
Mac PC prior to January 31, 2013; and (3) original LTV between 60 and 
80. \3\ The other transactions referenced similarly broad groups of 
loans. The sheer size and diversification suggests that there is little 
idiosyncratic risk in these pools.
---------------------------------------------------------------------------
     \3\ There were additional minor restrictions. Loans that were ever 
delinquent, found to contain underwriting defects, or had prepaid in 
full were excluded.
---------------------------------------------------------------------------
    The GSEs are retaining some risk on these deals, giving them ``skin 
in the game.'' In the three transactions that have been done to date, 
the GSEs have retained the first-loss position as well as part of the 
risk of the subordinate M1 and M2 tranches. For example, in the first 
STACR deal, total subordination was 3 percent. The first-loss position 
(B-H) was 30 bps, and the M1 and M2 slices were 135 bps apiece. Freddie 
retained the entire B-H tranche as well as about 17.8 percent of the M-
1 and M-2 slices (the M-1H and M-2H tranches). This is important 
because the GSEs have substantial control over the servicing practices, 
and this helps assure investors that these loans will be serviced no 
differently than anything else in the GSEs' portfolios.
    The timing of these transactions is discretionary. Since these 
assets are already on the GSEs' books, the risks can be laid off at any 
time. If one of the GSEs was thinking of doing a deal, but market 
conditions changed, it could be pulled until market conditions 
improved.
The Future State of the Mortgage Market
    There is a growing consensus the GSE reform is necessary. There is 
also a growing consensus on two principles:

    the private sector must play a far greater role in bearing 
        mortgage credit risk; and

    continued Government involvement is essential to ensuring 
        that mortgages remain available and affordable to qualified 
        homebuyers throughout the business cycle.

    Thus a number of proposals--including S.1217 (Corker-Warner); the 
Bipartisan Policy Council's Housing Commission (BPC HC), \4\ of which I 
was a part; and a paper coauthored by two of my Urban colleagues, Ellen 
Seidman and Sarah Rosen Wartell, and by Phillip Swagel and Mark Zandi 
(SSWZ), \5\--are aligned in proposing that the future state of the 
mortgage market should consist of mortgage originators and servicers 
who make the loans, a securitization platform, and a system of private 
credit enhancement. The securitizer must arrange for the private credit 
enhancement prior to securitization. There would be a limited 
catastrophic Government guarantee, paid for up front, which would be 
triggered only after all private capital available to support the 
mortgages had been exhausted.
---------------------------------------------------------------------------
     \4\ See, Bipartisan Policy Center Housing Commission, ``Housing 
America's Future: New Directions for National Policy'', February 2013.
     \5\ See, Ellen Seidman, Phillip Swagel, Sarah Rosen Wartell, and 
Mark Zandi, ``A Pragmatic Plan for Housing Finance Reform'', Moody's 
Analytics, the Milken Institute, and the Urban Institute, June 19, 
2013.
---------------------------------------------------------------------------
    The proposals suggest that private credit enhancement could take 
two different forms: a guarantor (bond insurer) framework and a capital 
markets framework. Both Corker-Warner and the BPC HC allow for both 
mechanisms in the reformed system, while SSWZ allows for the insurer 
alone. In all cases, the guarantor (insurer) is able to lay off risk 
through risk-sharing arrangements. I believe the form of the private 
capital will dictate the use and importance of risk-sharing 
arrangements in the future state. Moreover, the decision as to what 
form that first-loss piece takes is quite important and is not obvious; 
each approach has its strengths and weaknesses.
The Guarantor/Bond Insurance Framework
    In a guarantor framework, the bond insurer (guarantor) is liable 
for the credit enhancement up to the amount of its capital (as long as 
it is solvent). We assume GSE reform legislation would permit an 
insurer to voluntarily decide to lay off some of the risk on its 
transactions, and use structures similar to that being used in the 
STACR and CAS deals. The bond insurer would essentially play the role 
that Fannie and Freddie play in the current environment. This would 
allow bond insurers to employ these structures when it is cost-
effective to do so, so the timing would be flexible. There will be 
times when the capital markets bid will be lower than what bond 
insurers require, and guarantors will likely to try to lay off risk 
under such circumstances. This can be expected to occur when debt 
financing is trading cheaply relative to equity financing. Guarantors 
can also choose to lay off only part of the risk. This access to 
capital markets execution would also allow the bond insurers to do 
price discovery.
    It is very likely that the bond insurer would dictate minimum 
servicing standards in order to minimize its losses, just as Fannie and 
Freddie do today. Investors would probably require that the guarantor 
retain some skin the game, to gain assurance that the mortgage loans in 
which the risk has been laid off are not treated any differently than 
those in which the risk has not been laid off.
    However, risk sharing by the bond insurers under any of the 
proposals would be different from the STACR and CAS deals in one 
important respect. Investors are happy to take mortgage credit risk in 
synthetic form as embedded in Fannie Mae and Freddie Mac securities, 
because they believe the underlying entities are backed by the full 
faith and credit of the U.S. Government. If a bond insurer under any of 
the current proposals were selling the risk, the investor would be 
making a joint bet on the entity and the mortgage credit risk. The 
investors that evaluate mortgage credit risk are not necessarily the 
entities that take corporate credit risk. The result would be poorer 
execution. I believe the securities would trade at more favorable rates 
if one could separate the risk of the underlying entity (the corporate 
credit risk) from the mortgage credit risk, and allow for the issuance 
of credit-linked notes. This would require that transactions used to 
transfer mortgage credit risk be exempt from commodity pool rules.
    It is possible that the bond insurers would put together pools that 
are poorly diversified, but I believe the market will be unwilling to 
accept this. That is, investors are likely to believe that the insurer 
has better information than they do about any given loan, so if a pool 
is not a large representative sample, there is some chance the loans 
have been adversely selected, and the securities are likely to be 
priced accordingly. However, as long as the bond insurer itself is 
adequately diversified, and liable as long as it is solvent, then this 
is a business decision for a future bond insurers and investors in the 
securities, and not an issue for a future regulator.
Sizing Capital Requirements
    There are additional issues that would need to be dealt with in a 
future state that are not considerations for the GSEs in 
conservatorship. One of the most important is whether the institutions 
receive capital relief for risk-sharing transactions. I assume this 
would be the case, as these transactions would clearly allow the 
institutions to operate safely with less capital. However, the amount 
of any relief is more difficult to size than one might think. For 
example, if the amount of capital relief is fixed, a bond insurer may 
choose to transfer only its safest loans to the capital markets. The 
result would be that after the transaction, the bond insurer would be 
holding less capital than is prudent against a riskier set of loans. 
This problem could be partially solved by requiring a minimum absolute 
capital requirement, with a variable amount of capital relief for risk-
sharing transactions.
    There has been a considerable amount of conversation about how much 
capital is enough. Corker-Warner suggests 10 percent. The required 
capital should be sufficient to allow the institution to withstand 
severe stress. Many, including myself, believe the recent crises should 
be used to size capital requirements. The data that has been provided 
in support of the STACR and CAS risk-sharing deals has been invaluable 
to market participants in assessing mortgage credit risk, and can be 
used to size capital requirements. The data covers the performance of 
Fannie's and Freddie's books of business from about 2000 onward. 
Although it is limited to full-documentation fixed-rate amortizing 30-
year mortgages, excluding special affordability products, the structure 
of the loans is very similar to the business the GSEs are currently 
doing and are likely to do going forward.
    My colleagues and I at the Urban Institute have analyzed this data. 
\6\ We have shown that the 2007 Freddie Mac book of business, because 
of the subsequent nearly 35-percent drop in home prices nationwide, 
experienced cumulative ``defaults'' of 10.9 percent, the highest of any 
vintage year. A ``default,'' or ``credit event,'' as it is referred to 
in the risk-sharing transactions, is defined as a mortgage that went 
180-days delinquent or was liquidated prior to going 180-days 
delinquent by short sale, REO sale, or deed-in-lieu. To translate 
defaults to losses, we assume a severity of 40 percent, the highest 
number used in the three risk-sharing transactions, and multiply the 
severity by the default rate to size losses. \7\ Freddie's 2007 vintage 
10.9-percent default rate translates into a 4.4-percent loss rate. For 
the Fannie book of business, the cumulative credit event rate was 14.1 
percent, which translates into a 5.6-percent loss rate. Thus, it is 
clear that 5-percent capital would have allowed the GSEs to weather 
this very adverse environment. This is a conservative estimate in that 
it applies the worst vintage year to the entire business.
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     \6\ See, Laurie Goodman and Jun Zhu, ``The GSE Reform Debate: How 
Much Capital Is Enough?'', Urban Institute, October 2013, for more 
detail.
     \7\ The 40-percent severity covers the probability that a loan 
that goes 180-days delinquent goes on to liquidate multiplied by the 
severity if the loan eventually liquidates.
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    However, this analysis cannot be conducted in the abstract. It 
cannot be divorced from the question of how many insurers there would 
be and how to ensure that each one is adequately diversified. For 
example, for an insurer who insured loans in only one State, even a 10-
percent capital requirement might be insufficient. Similarly, if the 
regulator gave capital ``credit'' for credit-risk transfers, it would 
be conceptually possible for an insurer to lay off almost all the risk, 
keeping a small piece of nondiversified risk, which should demand 
significantly more capital than would have been needed to support the 
risk in the initial diversified book.
    A regulator is unable to be perfect, and unforeseen events occur. 
Thus, I suggest that some type of stress testing should be implemented. 
Certainly, the Federal Reserve's stress testing of systematically 
important banks has been a huge success. Stress testing would identify 
insurers that are nondiversified or have laid off risk in a manner than 
leaves them exposed. If the insurer failed the stress test, it should 
be required to take corrective action promptly, including cutting off 
dividends and raising capital within a well-defined period of time. If 
the insurer failed to take these actions, or was unable to raise more 
capital, it would be shut down, with the insurance transferred to 
another entity (similar to a servicing transfer in the current 
environment). This transfer could require a Government subsidy.
    Thus, when sizing the capital requirements, it seems clear that any 
new system relying on insurance should include the following:

    a 5-percent base capital requirement;

    additional risk-based capital requirements to cover 
        inadequate diversification or an unusually risky book of 
        business (e.g., an unusually high concentration of high-LTV or 
        low-FICO loans on the part of the insurer);

    capital relief for risk-sharing transactions, subject to a 
        minimum capital requirement; and

    stress testing of insurers, with corrective action required 
        if there is a stress test failure.

    Because sizing capital cannot be divorced from diversification, the 
ideal system should have a moderate number of well-diversified insurers 
that compete with each other. Too few institutions would limit 
competition and raise ``too big to fail'' concerns; too many are likely 
to be insufficiently diversified and operationally inefficient. I do 
believe it is necessary to have minimum diversification requirements.
    The design of a new system must also consider the role of 
traditional MI providers. By statute, Fannie and Freddie are required 
to lay off the risk on any mortgage greater than 80 LTV; that is, they 
are not permitted to bear this risk. Thus, a mortgage insurance 
industry has been established to take the risk on all mortgages over 
80-percent LTV. Under Corker-Warner, the mortgage insurers would stay 
largely as they are, though they would cover loans down to about 70-
percent LTV, and they could not also be bond guarantors. In my opinion, 
if one is remaking the system, it should not be taken as a given that 
the mortgage insurance industry remains as is. Both the bond insurers 
and the mortgage insurance companies would be assuming the same 
mortgage credit risk, hiring people with similar skills, and developing 
models to evaluate the credit risk. It may make more sense to combine 
the functions. However, if the functions were combined, it would be 
prudent to require bond insurers to hold more capital than in a system 
in which these functions remain separate.
    In short, the guarantor model can easily employ the risk-sharing 
techniques used in the STACR and CAS transactions, but the capital 
credit that is given for doing so cannot be divorced from the question 
of how capital requirements should be sized for the guarantors in a 
future system.
The Capital Markets Framework
    Under a capital markets framework for a new housing finance system, 
each security would require credit enhancement at the time of the 
securitization via a senior/subordinated bond market transaction or a 
synthetic alternative like Freddie and Fannie are using. The 
transactions would be more natural in nonsynthetic form. However, since 
there is no insurance entity, the transaction could not be done as a 
debt issuance; it would have to be a credit-linked note structure, with 
the originator as the deal sponsor. This, in turn, creates the problem 
that the deal is considered a commodity pool, an issue discussed 
earlier.
    Any capital markets solution must be combined with an insurance 
solution for several reasons. First, a pure capital markets solution 
relies on only one source of capital (the debt markets), with no 
flexibility to also rely on equity capital to take mortgage credit 
risk. Second, it requires the pricing of the credit enhancement to 
occur simultaneously with the securitization. There may be times when 
the pricing is quite unfavorable, and the originator would be forced to 
take that pricing, leading to more volatile mortgage rates for 
borrowers. Third, this structure is not kind to small lenders, who will 
have trouble aggregating a large enough pool of loans to obtain the 
required enhancement. That is, a small pool is almost by definition 
nondiversified and would command unfavorable pricing. Additional 
concerns include regulatory efficiency and effectiveness, the viability 
of the mortgage market during times of market stress, and ensuring 
broad-based credit availability. As a result, none of the GSE reform 
proposals advocate exclusively a capital markets solution. Corker-
Warner allows for both capital markets and guarantor arrangements, as 
does the BPC HC proposal. The SSWZ proposal does not allow for capital 
markets execution except in allowing an insurer to lay off some risk.
    If the capital markets solution is meant to coexist with the 
guarantor solution, the capital markets structure must either (1) use 
synthetic structures, or (2) if one were to use cash structures, the 
market must agree the senior bonds in the senior/subordinate structures 
are eligible for TBA delivery. This would require the market to 
simultaneously accept, as TBA, mortgages that reflect the full cash 
flow stream, as well as those in which the subordinated cash flows are 
not included. I am not sure the market will allow for this degree of 
flexibility.
Diversification
    The biggest problem I see with the capital markets solution, which 
is often overlooked, is that the interaction between the required 
capital and diversification is quite complicated, and hard to get 
right. Let us assume we fix the capital requirements at Corker-Warner's 
10 percent. As discussed in the previous section, our work at Urban has 
shown that under most circumstances a 5-percent capital requirement is 
more than enough. A 5-percent capital requirement would have been 
sufficient to cover, for their entire book of business, the losses 
Fannie and Freddie incurred on the 2007 origination activity, a vintage 
that experienced 35-percent home price declines. However, in a capital 
markets execution, even if you require 10-percent capital, it is easy 
to construct pools where inadequate diversification due to either size 
or geography means that is not nearly enough. For example, we looked at 
1,000 randomly selected pools of 2,500 Freddie Mac loans from the 2007 
vintage and found the mean default rate would have produced losses in 
the 4.0 percent to 4.5 percent area, with default rates on individual 
pools up to 1 percent higher and lower. \8\ But a pool of only Arizona 
loans had a much higher default rate than the Nation as a whole; the 
mean loss rate, using 40-percent severity, was in the range of 9.0 
percent to 9.5 percent. When we looked at 1,000 randomly selected pools 
of 2,500 loans, the loss rates ranged from 8 percent to 10.75 percent. 
When we looked at 1,000 randomly selected smaller pools of 100 loans, 
the loss rates of the pools ranged from 4.4 percent to 16 percent. 
Clearly, individual pools will be smaller than all the loans in a given 
Fannie or Freddie vintage, and the Government should want more first-
loss capital to come before its guarantee when pools are small, 
nongeographically diversified, or nondiversified in other ways. In 
contrast, the STACR and CAS securities were large, well-diversified 
pools, eliminating any nonsystematic results.
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     \8\ Laurie Goodman and Jun Zhu, ``The GSE Reform Debate: How Much 
Capital is Enough?'', Urban Institute, October 2013. In this article, 
we expressed the numbers as default rates, we have converted to 
severities for the purpose of this exercise.
---------------------------------------------------------------------------
    Thus, if a reformed system mandates a fixed amount of capital for 
capital markets transactions, it must also mandate diversification 
requirements. The new regulator would set the diversification 
requirements, but these requirements will be very hard to calibrate.
    Instead of a fixed capital standard, a risk-based approach could be 
used. One can imagine a system in which the originators enter the loan-
by-loan composition of a proposed pool into a system provided by their 
regulator, and the system tells them the capital necessary to support 
that pool. It's the equivalent of buying tomatoes at the supermarket, 
then bringing them to be weighed. It is cumbersome, and creates some 
pricing uncertainty. It also means that different pools will have 
different amounts of credit enhancement, and the redesigned TBA market 
must be willing to accept this.
    These diversification issues are further compounded for smaller 
originators. It is not clear how they get the number of loans needed 
for a capital markets offering. Even if they could get a critical mass 
of loans, those loans are apt to represent insufficient 
diversification. It is unlikely smaller lenders could utilize a capital 
markets solution without an aggregator. If there is a parallel 
guarantor execution vehicle, this issue is still difficult, although 
less critical. In short, the interaction between required capital 
(subordination) and diversifications is complicated, and there is no 
silver bullet.
Conclusion
    The STACR and CAS transactions have clear applicability in any new 
housing finance system. If a guarantor structure is used, the guarantor 
plays the role of Fannie and Freddie. The largest issue relating to 
risk transfer in this model is what credit the guarantor will receive 
for laying off these risks on the capital markets. I definitely believe 
credit should be given, as transferring risk allows the guarantors to 
operate safely, with less capital.
    If the new housing finance regime allows for both a guarantor 
execution and a capital markets execution, the big issue with risk 
transfer is how to ensure adequate diversification to protect the 
Government. If a fixed capital requirement is mandated, the regulator 
must ensure adequate diversification on each individual pool. If a 
risk-based capital requirement is used, it requires substantial 
calibration on the part of the regulator, as well as some uncertainty 
for the lender, as the lender does not know the capital requirement 
until the pool is final.
    More generally, three conclusions emerge from this analysis:
    First, it is important to resolve the commodity pool issue so that 
synthetic structures using credit-linked notes, which allow for 
separation of the risk of the sponsoring entity from the credit risk on 
the mortgages that are being transferred, can be used.
    Second, in any future state, capital regulation for guarantors 
should include stress tests, a base capital ratio of 5 percent, a risk-
based component, and capital relief for credit-risk transfer, subject 
to a minimum absolute capital requirement.
    Third, in the future state, the system must have a guarantor 
(insurer) execution, and not rely solely on the capital debt markets to 
lay off credit risk. This is necessary in order to promote the TBA 
market, allow for the presence of small lenders, assure broad-based 
credit availability of credit, and be resilient during periods of 
market stress.



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