Freddie Mac is making some big changes to its program transferring the credit risk of residential mortgages to the capital markets.

Investors in Structured Agency Credit Risk (STACR) notes, a few of them, at least, will now be paid for taking the first 100 basis points of loss when homeowners stop making payments on mortgages insured by the government sponsored enterprise. Previous deals required losses to reach a threshold before the company received funds to cover them.

"Freddie Mac is shifting its credit risk business strategy from a buy and hold company to a buy and sell company, so it is natural that we would further reduce our credit risk exposure by selling the first loss piece," Mike Reynolds, Freddie Mac’s vice president of credit risk transfer, said in a press release. "We have heard from numerous investors who have an appetite for more risk and higher yields like those found in the first loss piece."

Freddie is planning for six to eight STACR issuances this year, depending on market conditions. The notes are issued at par and pay an interest rate pegged to LIBOR over a period of 10 years. They are general obligations of Freddie Mac, but the mortgage giant may hold on to investors’ principal if enough loans in a $27.6 billion reference pool become more than 180 days delinquent.

The first offering of the year, announced Tuesday, consists of four classes of notes:  $200 million of M-1 notes, rated A2 by Moody’s Investors Service and A by DBRS, are on the hook when delinquencies of the reference pool reach 3.5%; $200 million of M-2 notes, rated Baa1/BBB, have an attachment point of 2.5%; another $300 million of M-3 notes, rated Ba1 by Moody’s, have an attachment point at 1.0%. In previous STACR transactions, the M-3 class of notes was unrated.

For the first time, there is also a $75 million tranche of B notes that take the first 100 basis points of loss, meaning that investors are virtually guaranteed to lose some of their principal. (After all, it’s unlikely that not one of the 121,129 loans in the reference pool will ever become 180 days delinquent.) If the delinquencies in the reference pool reach 1.0%, the principal of the B notes will be exhausted.  

How likely is this to happen?

The offering’s investor presentation includes a chart indicating that the class B notes would have taken 100% losses on similar reference pools of loans originated in four different years: 2005, 2006, 2007 and 2008. For that matter, the M3 class would have taken a 100% loss on the 2007 and 2008 proxy reference pools as well. (The reference pool proxies are created by weighting data through December 2013 in proportion to the credit scores and the amount of equity of borrowers in the actual reference pool for the current offering.)

This class B notes have a pretty narrow appeal. They are unrated, are restricted to U.S. persons, and will be treated as a derivative for U.S federal income tax purposes, all of which restrict the potential investor base. And since Freddie is retaining 50% of the tranche, there is only $37.5 million to go around.   

As in past STACR transactions, Freddie is also retaining a portion (at least 5%) of the M-1, M-2, and M-3, notes; it is also on the hook for any losses in the reference pool of loans after the senior M-1 class is wiped out.

J.P. Morgan and Citigroup will serve as co-lead managers and joint bookrunners for STACR Series 2015-DN1.

The credit quality of the reference pool of loans, all of which were originated between April 1 and July 31, 2014, is very similar to that of Freddie’s past three STACR transactions: the average principal balance is $228,000, the average loan-to-value ratio at the time of origination was 76%; and the weighted average FICO of the borrowers was 753. Roughly two-thirds of loans are for purchases, 17% are cash-out refinancing and 16% are no-cash out refinancing.

Freddie and sister mortgage company Fannie Mae are required by their regulator, the Federal Housing Finance Agency, to offload the credit risk of mortgages to private investors in order to lessen the exposure of taxpayers. To date the GSEs have issued a combined total of some $12 billion of debt securities transferring mortgage credit risk.  

Fannie’s Connecticut Avenue Securities program, which is analogous to Freddie’s STACR program, does not currently transfer the first loss risk. However, Fannie has engaged in other types of transactions that transfer the first loss, including one with JPMorgan Chase and another with Redwood Trust. Both Fannie and Freddie have also offloaded credit risk via reinsurance.

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