The debt securities that Fannie and Freddie issue to share mortgage risk with private investors have been a big hit with investors. The two primary programs, Connecticut Avenue Securities (Fannie) and Structured Agency Credit Risk (Freddie), function like catastrophe bonds. The principal is available to the issuer in the event that losses on a reference pool of single-family mortgages reach a predetermined level.

This kind of reinsurance is one of the few means available to either GSE to raise capital while they are in conservatorship. Yet many contend that CAS and STACR are not the right kind of capital. There are two primary arguments. The first is that it could prove tough to raise this capital at precisely the point in the housing market cycle when it’s most needed. Investors would be too skittish. The GSEs certainly got a taste of this during a bout of broader capital market volatility early in 2016. They both shifted their emphasis, temporarily, to other kinds of risk sharing where the counterparties are insurers, not capital markets investors.

The second argument is that CAS and STACR don’t transfer enough risk, and that if they did, there might not be enough ready buyers. This argument is more complicated. Critics note that, in the first nine months of 2016, Fannie and Freddie sold securities tied to $1.2 trillion in mortgages, but with only $35 million of risk transferred. That’s partly because CAS and STACR, as currently structured, are only designed to transfer the first 5% or so of losses.

What’s more, the risk may not be transferred for that long. CAS and STACR have 10-year tenors, but the mezzanine tranches that transfer early losses receive their proportional share of principal repayment when mortgages in the reference pool are refinanced. “If interest rates fall and the rate of voluntary prepayments is high … the outstanding balance at time of correction will be relatively low,” said Zach Cooper, deputy chief investment officer at Semper Capital.

This is part of the appeal, Cooper said. “As an investor in the M [mezzanine] class, every year that goes by with high prepayments, my total return looks better and better.”

How much more risk could they transfer to the capital markets, and at what price? Certainly more than the GSEs are currently selling. The investor base for even the riskiest tranches of these deals continues to grow. In January, the National Association of Insurance Commissioners released designations for iterations of CAS and STACR that transfer actual losses, as opposed to those transferring estimated losses.

“They seem to be experimenting with what works best for them and the market,” Cooper said. “But the byproduct of such small issuance is that a relatively small change in performance assumptions can really move spreads. Two billion dollars outstanding is a tiny product. We expect the GSEs to continue to experiment with this and use if to offload risk on a larger and larger percentage of their book as they get more comfortable with product, and that will damp spread volatility.”

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