July 26 (IFR) - Bank buyers kept their distance from the inaugural Freddie Mac risk-sharing mortgage bond this week, fearful of punitive risk-weighting charges on the new type of security, according to industry experts.
Barely a handful of banks bought the US$500m of securities, which were upsized from US$400m at pricing. Insurance companies were also not the most active buyers, as they would have liked the security to have a rating from the US National Association of Insurance Commissioners (NAIC), sources said.
About 50 investors bought the unrated Structured Agency Credit Risk (STACR) 2013-DN1, including hedge funds, pensions, money managers, REITs, credit unions, and a few insurance companies.
Spreads initially widened considerably from initial price whispers last week, but then tightened in at pricing on Tuesday. The two-tranche structure offered tenors of 2.19 and 8.21-years, respectively. Pricing levels were set at one-month Libor plus 340bp and 715bp.
Even though the new bond is considered an obligation of Freddie Mac, the typical 20% risk weighting assessment for Fannie and Freddie agency MBS would not be applied to this deal.
Some of the first-loss risk is being laid off to the private capital markets, and the deal is closer to a senior/subordinate private-label RMBS. The risk-weighting charge would likely be much higher if banks held the security.
"It's difficult for banks to invest in this; the risk weightings would matter to them," said Kevin Palmer, the vice president of costing and portfolio management at Freddie Mac.
"We did meet with some banks, but it's unclear what the risk weighting would be," given some of the complex formulas currently being suggested under Basel III rules to formulate charges for risk-weighted assets, including structured products held by banks.
There will likely be one more STACR transaction toward the end of 2013, and "then we will determine the appropriate issuance frequency in 2014," Palmer told IFR. "Our goal is to have standardized structuring and consistent frequency of issuance, making the product more predictable."
Consistent feedback from investors reflected the fact that they would prefer to have the next transaction rated, said Palmer.
"There is only so much capital investors can put into unrated assets," he noted. "We are working with rating agencies to have it rated in the future."
Money managers, in particular, were pressing for rating-agency grades, since ratings give them more flexibility to put the STACR bonds into funds.
Freddie Mac is also in preliminary talks with the NAIC to potentially rate the bonds so that more insurance companies can hold them. Typically, the NAIC does not rate new offerings, but assigns grades once the securities are held in insurance-company portfolios.
"We are working with the NAIC to be able to give some sort of rating to these bonds once they are in insurers' portfolios," Palmer said. "With NAIC ratings, I think participation from insurance companies will increase quite dramatically."
Since 2009 the NAIC has been providing US insurance companies and regulators with credit assessments of legacy RMBS and CMBS in order to estimate risk-based capital requirements.
The NAIC's alternative approach to ratings, which differs from credit rating agency grades, has been viewed by many in the market as a more precise assessment of the value of RMBS held by insurers.
Another favorable trait of the first STACR deal is that there is no concept of so-called "servicing advances" in the structure. In typical non-agency RMBS deals, servicers must put money up front for loans that have become delinquent; therefore, servicer advances are typically an important part of how investors will bid on deals.
Investors usually scrutinize who the servicer is, and how much has been advanced.
In the Freddie Mac STACR transaction, however, the GSE pays full coupon to investors the entire time the loan is in the structure. Moreover, the structurers tried to limit investors' downside risk by deploying a fixed, but tiered, loss-severity structure, which protects against unforeseen and hard-to-predict problems.
During the last downturn, for instance, foreclosure timelines were extended, and there were many new laws put in place in various municipalities that extended the timelines even further. This meant increased risk for holders of RMBS.
On the flip side, however, some bond investors complained that the fixed severities in Freddie's deal also limits their upside, should the market improve, which Palmer said was a somewhat fair statement.
However, the "tiered" severity structure accounts for both high levels of "curing" of mortgage defaults in a good market, or an increase in loss severities as the market deteriorates.
In fact, the lack of this "tiering" in the fixed loss severities is partially what derailed an earlier attempt at risk-sharing bonds by the GSE in 1998, Palmer said.
Freddie attempted a somewhat similar product that year, called Mortgage Default Recourse Notes (MODERNS), a one-off insurance-like derivatives transaction that exhibited numerous structural and conceptual weaknesses, and was largely deemed a failure.
Market players describe that effort as an attempt to create a "funded alternative to mortgage insurance".
The STACR deals bear structural similarities to MODERNS, but have a different purpose -- bringing private capital back into mortgage finance -- and are being released into a different economic environment.
"We're trying to limit policy risk to investors," Palmer said. "We don't do principal forgiveness, but if we ever did it, the portion of principal forgiven would be passed through to investors," meaning that bond investors wouldn't take any loss on the principal forgiven to borrowers.
"We're limiting investors' exposure to policy changes they're concerned about."
The risk-sharing bonds are part of an effort by the GSEs' regulator, the Federal Housing Finance Agency, and the US government, to gradually wind down and phase out the GSEs' overwhelming footprint in the market. The two companies currently finance nearly 90% of the country's mortgages.
The taxpayer-backed organizations, which were put into government conservatorship in 2008 after suffering heavy losses due to the implosion of the non-agency RMBS market, have been instructed by the FHFA to conduct US$30bn in various risk-sharing programs this year.