In part one of a series of papers authored by former Freddie Mac CEO and Harvard Joint Center for Housing Studies (JCHS) Senior Industry Fellow Don Layton, Layton explained the purpose and role of the Credit Risk Transfer (CRT). Now, in Demystifying GSE Credit Risk Transfer: Part II – How, and How Well, Does It Work?, Layton dives into the behind-the-scenes of the CRT.
“Today, over six years later, more than 70% of the credit risk on new single-family mortgages is transferred to private market investors,” said Layton. “Given that the two GSEs together have about $5 trillion of single-family mortgage credit exposure outstanding, this means very large amounts of risk are being transferred–something almost unimaginable when Freddie Mac introduced the first transaction as a somewhat experimental initiative in July 2013.
As Layton notes, CRT operates across four different types of financial transactions: Securities Issuances, Insurance/Reinsurance, Lender Risk Sharing, and Senior/Subordinate. These transactions must work properly in order for a CRT to function smoothly and transfer risk correctly. On top of these four transactions, Layton notes that there are six key criteria by which to determine if a particular type of CRT is truly effective in transferring risk.
Of the four transaction types, Layton found that two seem to be doing the job well, one is so non-transparent that the public can’t come close to determining how well it works, and one has material weaknesses that should be addressed by the FHFA if it is to be allowed to continue.
The objective of the proposed six major requirements for CRT of GSE TBA-eligible mortgages to be truly effective from both the GSE and policy perspectives is to “deliver a risk transfer that operates both efficiently and effectively, with no loopholes, caveats or surprise exceptions such that the credit risk somehow boomerangs back to the GSE, and in a manner supportive of financial market stability.”