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Study of the Use of Credit Enhancements by Government Sponsored Enterprises Final Report

Contract # C-OPC-05978 February 2001 Prepared for John Gardner U.S. Department of Housing and Urban Development 451 7th Street, SW, Room 8212 Washington, DC 20410-3000 Prepared by Kimberly Burnett Christopher E. Herbert Brian Maris

Cambridge, MA Lexington, MA Hadley, MA Bethesda, MD Washington, DC Chicago, IL Cairo, Egypt Johannesburg, South Africa

Abt Associates Inc. 55 Wheeler Street Cambridge, MA 02138

Table of Contents i

Table of Contents

I. Introduction .............................................................................................................1Background ...............................................................................................................1Purpose of the Study..................................................................................................2Methodology .............................................................................................................3Outline of Report .......................................................................................................4

2. GSE Use of Credit Enhancements ..........................................................................5Fannie Mae Multifamily .............................................................................................5

Delegated Underwriting and Servicing ................................................................5Negotiated Transactions....................................................................................10Small Multifamily Loans....................................................................................14

Freddie Mac Multifamily ..........................................................................................15Program Plus ....................................................................................................15Negotiated Transactions....................................................................................17

Single Family ...........................................................................................................18GSE Charter Requirements ...............................................................................18Other Forms of Credit Enhancement .................................................................21CRA Loans.......................................................................................................23

3. Non-GSE Use of Credit Enhancements ................................................................24Federal Home Loan Bank Mortgage Partnership Finance Program ...........................24

Program Overview............................................................................................24Relief from Capital Requirements......................................................................26MPF Products...................................................................................................26Determining the Level of Credit Enhancement...................................................30Volume.............................................................................................................31MPP .................................................................................................................31

Non-agency Securities .............................................................................................32Residential Mortgage-Backed Securities ...........................................................32Commercial Mortgage-Backed Securities..........................................................34

4. Conclusions ............................................................................................................39Motivations for the Use of Credit Enhancement .......................................................39Credit Enhancements in the Single Family Mortgage Market ....................................41Credit Enhancements in the Multifamily Mortgage Market .......................................43Likely Future Trends in the Use of Credit Enhancements..........................................44

Table of Contents ii

Appendix A - Review of Literature Related to Information Asymmetries and CreditEnhancements in Transactions Between GSEs and Mortgage Lenders .........................47

Abstract ...................................................................................................................47Overview .................................................................................................................47I. Literature Related to Information Asymmetries and Credit Rationing ..............48II. Literature Related to Information Asymmetries and Financial Intermediation ..49III. Literature Related to Efficiency Properties of Credit Enhancements in the

Context of Information Asymmetries ..............................................................52IV. Information Asymmetries and Secondary Markets...........................................56Sources Cited ..........................................................................................................61

Appendix B - Inventory of Credit Enhancements............................................................63

Appendix C - Acronyms....................................................................................................66

Study of the Use of Credit Enhancements by Government Sponsored Enterprises – Final Report 1

I. Introduction

Background

Credit enhancements refer to a variety of approaches designed to reduce the credit riskexposure of investors in financial instruments backed by mortgages. Through agreements tocover losses in specified circumstances, some or all of the instruments’ credit risk istransferred from the owners of the mortgage-backed instruments to the credit enhancer.

Credit enhancements on mortgages purchased in the secondary market are used to accomplishtwo goals: to provide primary lenders with an incentive to carefully underwrite mortgages andto place the credit risk on the party that can most efficiently bear it. Credit enhancementssuch as risk sharing or recourse agreements help solve the problem of asymmetric informationthat sometimes exists when loan originators have better information than investors. Risksharing and recourse agreements do this by providing financial incentives that align theinterests of the loan originator and the investor in making prudent underwriting decisions.

Credit enhancements such as mortgage insurance and pool insurance shift the burden of creditrisk from an investor to an insurer. Through agreements to cover losses in specifiedcircumstances, some or all of the instruments’ credit risk is transferred from the owners of themortgage-backed instruments to the credit enhancer. The credit risk may be more efficientlyborne by the insurer because of the regulatory environment or superior knowledge or businesspractices.

Some of the most common credit enhancements include:

• Mortgage insurance: Insurance that covers losses on a mortgage up to a specifiedpercentage of the unpaid principal balance at the time of default.

• Pool insurance: Insurance that covers losses on a mortgage pool up to the dollaramount of the policy.

• Spread accounts: Accounts used to capture the excess cash flow over the servicingfees and interest payments on a mortgage-backed security (MBS). Funds thatbuild up in spread accounts are used to cover losses from mortgage default as theyoccur.

• Repurchase agreements: Agreements that require the seller of a mortgage to buythe mortgage back if the mortgagor defaults on his/her obligation and it is foundthat underwriting requirements were not properly observed when the loan was soldin the secondary market.


• Senior/subordinated structures: Cash flow generated by mortgages used ascollateral is divided into groups, or tranches, to create securities of varyingmaturity and risk. Losses related to default are absorbed first by the residual andsubordinate tranches, providing protection to the senior tranche from credit risk.

• Recourse or risk sharing: Agreements that divide default-related losses from anindividual mortgage or a pool of mortgages between parties, for example, themortgage seller and the guarantor of the mortgage or mortgage pool.

A more complete list of credit enhancements and their definitions is provided in Appendix B.

Purpose of the Study

The main purpose of the study is to deepen HUD’s understanding of how and why creditenhancements are used by Fannie Mae and Freddie Mac, the two principal government-sponsored enterprises (GSEs), in their secondary mortgage market transactions involving bothsingle-family and multifamily housing.1 In its report evaluating HUD’s effectiveness as aregulator of the GSEs, the General Accounting Office (GAO) emphasized the need foradditional research regarding seller-provided credit enhancements on multifamily mortgagesacquired by the GSEs.2 The GAO questioned whether the widespread use of recourse by theGSEs in their multifamily acquisitions limited lenders’ incentives to originate multifamilymortgages and promote housing opportunities.3 In addition, a relatively high proportion ofthe GSEs’ multifamily mortgage purchases count for compliance with numeric housing goalsestablished by HUD requiring the GSEs to purchase mortgages serving targeted groups.GAO also questioned whether the GSEs should receive full credit for multifamily mortgagepurchases where the mortgage originator provides credit enhancements that require them tocover most default-related losses.

As an illustration of the importance of credit enhancements to the GSEs, in 1999, Fannie Maesustained approximately $400 million in single family and multifamily credit losses. Of this,about $125 million ($118 million for single family and $7 million for multifamily) was borneby Fannie Mae. The other $275 million was assumed by risk-sharing partners, most of whichwas primary mortgage insurance.

1 Throughout the paper, the term GSE is used to refer only to Fannie Mae and Freddie Mac, although there

are other GSEs.

2 U.S. General Accounting Office, “Federal Housing Enterprises: HUD’s Mission Oversight Needs to beStrengthened,” (GAO/GGD-98-173) July 1998.

3 Federal Register, Vol. 65, No. 211, October 31, 2000, p. 65080. Part II: Department of Housing andUrban Development, 24 CFR Part 81.


In this study, we have examined the GSEs’ use of credit enhancements to mitigate credit riskin both their single family and multifamily mortgage purchases.4 The use of creditenhancements by non-GSE participants in the secondary mortgage market is then surveyed toprovide a point of comparison with the GSEs’ approach. Because the FHA mortgageinsurance that provides credit enhancement for Ginnie Mae issued securities is wellunderstood, we have focused primarily on non-agency issuers, which are entities that issueMBS other than Fannie Mae, Freddie Mac, and Ginnie Mae, including the Federal Home LoanBanks (FHLBs) and non-federally chartered issuers.

Another goal of this study is to provide a literature review and theoretical analysis exploringasymmetric information as it relates to the use of credit enhancements by the GSEs in themortgage market. Asymmetric information exists when one party in a transaction hasinformation about the transaction that the other does not. There does not appear to be anypublished research that addresses the issue directly. There is, however, an extensive literaturethat addresses the implications of asymmetric information in the credit and securities markets,and in particular, the implications of asymmetric information in the sale of loans. Many ofthese studies discuss the resource allocation effects of alternative arrangements, and comparethe resulting equilibrium with that which would exist with perfect symmetric information. Themajority of the published work on this topic takes the view, or implies, that the use of creditenhancements has the potential to improve the efficiency of market outcomes in the context ofinformation asymmetries. The complete literature review is contained in Appendix A.

This study first discusses the major types of credit enhancements and their relative prevalence,circumstances under which each is typically used, and the purposes served by the creditenhancements. Multifamily transactions generally involve a greater variety of creditenhancements because of the greater risk associated with these investments and theunavailability of mortgage insurance for most multifamily transactions.5 As a result, the reportplaces a somewhat greater emphasis on the use of credit enhancements in multifamilytransactions.

Methodology

To address the study issues, we first held a series of discussions with representatives of theGSEs. Second, we conducted Internet searches and reviews of research from rating agenciesand other observers and participants in the non-agency market. We next held interviews withkey informants such as representatives of depository institutions, regulatory agencies, creditenhancement providers and ratings agencies about the use of credit enhancements in the

4 Circumstances where the GSEs credit enhance other transactions are outside the scope of this study.

5 FHA does provide multifamily mortgage insurance but FHA’s involvement is limited to the low- andmoderate-income segment of the market.


agency and non-agency market. Last, we conducted a theoretical exploration of therelationship between credit enhancements and market efficiency in the secondary market formortgages. This theoretical exploration discusses the relevance of the existing literature tothe secondary market situation faced by the GSEs.

Outline of Report

Chapter 2 describes the GSEs’ use of credit enhancements in the multifamily and single familymarkets. In the multifamily market, this includes a review of Fannie Mae’s DelegatedUnderwriting and Servicing (DUS) product, Aggregation Facility, and 5-50 product for smallmultifamily properties, Freddie Mac’s Program Plus, and both GSEs’ use of structuredtransactions. The single family portion of Chapter 2 describes the GSEs’ use of creditenhancements to comply with the requirements of their charters, as well as other creditenhancements including pool insurance and structured transactions using subordination, anddescribes trends in the GSEs’ use of credit enhancements. A short discussion of the GSEs’purchases of Community Reinvestment Act (CRA) loans is also included. Chapter 3 describesour findings from interviews and research conducted on the credit enhancements used by non-agency participants in the secondary mortgage market. An in-depth review of the FHLBs’Mortgage Partnership Finance program is included, and credit enhancements used by non-agency mortgage-backed security issuers are described. The final chapter summarizes themotivations for the use of credit enhancements in secondary market transactions, contrasts theuse of credit enhancements by the GSEs and other market participants and discusses thereasons for any differences, and concludes with a brief discussion of factors that are likely toaffect future trends in the use of credit enhancements. Appendix A contains the literaturereview and theoretical analysis, Appendix B provides a glossary of key terms, while AppendixC lists the acronyms used in this report.


2. GSE Use of Credit Enhancements

This chapter describes the use of credit enhancements by Fannie Mae and Freddie Mac in theirmultifamily and single-family transactions. Since there are significant differences in the use ofcredit enhancements on multifamily transactions between the GSEs, the first two sectionsdescribe the use of credit enhancements by each GSE in multifamily transactions. The lastsection of the chapter then describes the use of credit enhancements by the GSEs in single-family transactions, indicating any notable differences in the practices of the two firms.

Fannie Mae Multifamily

Fannie Mae makes extensive use of credit enhancements in its multifamily transactions.Fannie Mae’s primary source of multifamily loans is through its network of DesignatedUnderwriting and Servicing (DUS) lenders. In the DUS product, lenders share in the risk oflosses in exchange for greater autonomy in underwriting and servicing loans sold to FannieMae. While the DUS product accounts for the majority of its multifamily loan purchases,Fannie Mae also acquires a significant volume of loans in negotiated transactions, many ofwhich also entail seller-provided credit enhancements. The sections below provide a detaileddescription of each of these products and the forms of credit enhancements used in thesetransactions. The final part of this section provides a discussion of a new Fannie Mae productdesigned to provide financing for small properties with between 5 and 50 units.

Delegated Underwriting and Servicing

The DUS product, created in 1988, is Fannie Mae’s principal avenue for purchasing individualmultifamily loans. In 1999, DUS debt financings accounted for $7.2 billion of Fannie Mae's$12.4 billion in total multifamily volume.6 Fannie Mae agrees that it will purchase loans fromDUS lenders without re-underwriting those loans prior to purchase if the lenders process andapprove the loans in accordance with Fannie Mae’s written guidelines. In exchange, DUSlenders take a share of the risk. According to Fannie Mae, DUS lenders benefit from thisrelationship because they have greater autonomy in originating and servicing loans. Inaddition, lenders are more competitive due to the speed provided by DUS for originating,underwriting and closing loans.

According to Fannie Mae’s DUS Guide, DUS lenders are subject to capital and liquiditystandards; the lending institution must have sufficient financial strength to support its losssharing obligations. A DUS lender is required to have an “acceptable net worth” of at least$7,500,000 and at least $500,000 of assets must be liquid. These minimum net worth and

6 www.fanniemae.com, February 8, 2000 press release.


asset requirements must be met before a lender puts any DUS loans on its books, and higherlevels are mandated as the lender’s risk sharing responsibilities increase. In addition, FannieMae requires that its lenders submit annual operating statements, and conducts periodicassessments of lenders.7

Loans originated by DUS lenders have performed very well to date. According to FannieMae, there have been 88 defaults in the history of the DUS product for the more than 7,000loans originated by DUS lenders to date. Levels of delinquency are fairly low as well: inAugust 2000, the delinquency rate was 5 basis points (i.e., 5/100ths of a percentage point) for60 days. Although Fannie Mae said these levels are lower than the historical average for theseloans and reflect the strong economy, delinquency levels generally have been fairly low sincethe inception of the product. In cases where there have been defaults, lenders have alwayscovered their share of the losses as specified in their loss-sharing agreement, described in thenext section.

Until 1994, Fannie Mae held most DUS-originated loans in its own portfolio. With theinitiation of the MBS DUS product in August 1994, Fannie Mae began to routinely securitizeDUS loans for sale as MBS. These MBS have the same guarantee of full and timely paymentof principal and interest as Fannie Mae’s single-family securities. DUS loans have fairly rigidunderwriting standards and a high level of standardization, allowing for efficient securitization.

DUS Product Credit EnhancementsDUS lenders must enter into loss-sharing arrangements with Fannie Mae. Fannie Mae’s DUSGuide describes three loss-sharing regimes, referred to as “Loss Levels.” The Loss Levelsassign the lender with varying levels of responsibility for first loss coverage, which require thatlenders cover all losses up to a set percentage of the original unpaid principal balance (UPB).The first loss coverage ranges from 5 to 15 percent of the original UPB. Loss sharingbetween the lender and Fannie Mae occurs on losses that exceed this first loss coverage. TheLoss Levels specify separate shares of losses to be borne by lenders beyond the first losscoverage up to 20 percent of the original UPB and in excess of 20 percent of the originalUPB.8 Exhibit 1 below summarizes the loss sharing arrangements under each of the LossLevels. Under Loss Level I, lenders have the least responsibility for losses, under Loss LevelIII, the greatest. According to Fannie Mae, the Loss Level is assigned on a deal-by-deal basis,although most loans are assigned Loss Level I unless they are non-standard in some way, inwhich case a higher Loss Level may be negotiated. A higher Loss Level is imposed as apenalty in the event of the lender’s breach of provisions of its agreements with Fannie Mae.These levels are the same regardless of the execution selected, although the majority of loansare securitized and sold as MBS.

7 Fannie Mae DUS Guide.

8 Fannie Mae DUS Guide.


Exhibit 1Summary of Lender Risk Exposure in Fannie Mae’s DUS Product

Loss Level

First LossCoverage

(Percent ofOriginalPrincipalBalance)

Lender’s Share ofAdditional Losses

Up to andIncluding 20

Percent of UPB

Lender’s Shareof Remaining

Losses GreaterThan 20 Percent

of UPB

MaximumLender Loss(Percent of

OriginalPrincipalBalance)

I 5 25 10 20

II 10 40 25 30

III 15 50 30 40

Source: Fannie Mae DUS Guide.

Fannie Mae officials said that in unusual circumstances, when the costs associated with defaultare high, lenders could reach their maximum loss. Default costs could be high if there is along bankruptcy or foreclosure process, if costs of litigation such as environmental litigationare very large, or if the property disposal process is lengthy, resulting in high carrying costs.

Under these loss-sharing arrangements, DUS lenders are not responsible for 50 percent ormore of the original principal balance unless additional loss is attributable to missing collateralfor which the lender is liable. If, as suggested by Fannie Mae, Loss Level I is the mostcommon loss-sharing arrangement used, then in general DUS lenders are responsible for amaximum of 20 percent of the original principal balance in the unlikely event that either noneof the principal is recovered through foreclosure and sale or costs associated with foreclosureare very high. The share of losses borne by the DUS lender depends on the percent of UPBthat has been paid, but as a rough approximation, under loss assumptions of 30 to 60 percentof UPB, DUS lenders under Loss Level I would be responsible for losses amounting tobetween 10 and 13 percent of the original principal balance.

It is important to note that in the discussion above losses are measured in terms of share ofthe original loan balance, which is distinct from the unrecovered share of the unpaid principalbalance at the time the loss is incurred; this concept is referred to as the loss severity. Anotherconcept is the share of losses borne by the lender. Given the sliding scale for loss sharingdescribed above, the lender’s share of losses declines as the loss severity increases. Forexample, as illustrated in Exhibit 2, under Loss Level I arrangements, the lender is responsiblefor 100 percent of losses if the loss severity is 5 percent of the UPB or less. Once lossesexceed 5 percent of UPB, the majority of additional losses are borne by Fannie Mae so thelender’s share of losses quickly declines. The lender’s share of losses reaches 50 percentwhen the loss severity is 15 percent of the UPB. In the extreme case that the loss severity is100 percent (that is, none of the UPB is recovered), the lender’s share of losses would reach


its minimum, which is 20 percent. Thus, the degree of credit enhancement called for under theloss sharing arrangements used by Fannie Mae in its DUS product is not a constant share ofthe losses, but rather is a function of the loss severity.

Source: Author’s calculations based on information from Fannie Mae DUS Guide.

GAO implicitly suggested in its 1998 report that loss-sharing levels in the DUS product becompared with those used in the FHA risk-sharing reinsurance program. As noted in theGAO report, at that time the counting rules for the GSE housing goals specified that theGSEs only receive credit for loans purchased under FHA risk-sharing arrangements where theGSE is responsible for “a substantial amount (50 percent or more) of the risk.”9 The GAOstudy implicitly raised the question of whether this exclusion ought to be applied to other losssharing arrangements. However, the loss sharing arrangements with FHA do not entail asliding scale of loss sharing. Under FHA’s risk-sharing reinsurance program, the GSEs areeligible to enter into a risk-sharing agreement with FHA where the GSEs assume 50 percentof losses. In this case, both FHA and the GSEs are exposed to the risk of very large losses (asa percent of UPB) that result from unexpected circumstances such as natural disaster or asevere economic downturn. 9 U.S. Department of Housing and Urban Development, “The Federal National Mortgage Association

(Fannie Mae) and the Federal Home Loan Mortgage Corporation (Freddie Mac) Regulations Final Rule,”Federal Register 60:231 (December 1, 1995), p.61893.

Exhibit 2Share of Losses Borne by Fannie Mae DUS Lenders as a Function of Loss Severity Under Alternative Loss Sharing Arrangements

0%

25%

50%

75%

100%

5% 15% 25% 35% 45% 55% 65% 75% 85% 95%

Loss Level I

Loss Level II

Loss Level III

Share of Losses

Loss SeverityNote: Loss Severity is total losses incurred on a loan as a percent of the unpaid principal balance. Loss Levels refer to alternative loss sharing arrangements in the DUS program.


The comparison of the FHA risk-sharing program with the DUS product is notstraightforward because two distinct definitions of risk can be considered. In the FHA risk-sharing program, both the GSEs and FHA are exposed to risk of large loss. In the DUSproduct, under the most common (Loss Level I) arrangement, lenders’ exposure to loss islimited to 20 percent of the original principal balance of the loan. In the most extreme case ofLoss Level III loss sharing, lenders’ maximum exposure is 40 percent of the original principalbalance. Under this definition, Fannie Mae always takes more than half of the risk.

If risk is defined as the expected loss faced by Fannie Mae and the DUS lenders, severalassumptions must be made in order to compare the DUS product with the FHA risk-sharingreinsurance program. Specifically, in order to determine whether the loss sharingarrangements under the DUS product expose Fannie Mae to 50 percent or more of theexpected loss, assumptions have to be made about the degree of loss severity and the amountof the original loan balance that has been paid down.

The expected degree of loss severity may be estimated from historical experience. A report byFitch IBCA notes that Freddie Mac’s historical multifamily loss severity has been in the rangeof 45 to 60 percent of UPB, while Fannie Mae’s historical losses have been 25 to 30 percentof UPB.10 An upper-bound estimate of expected loss severity may be that estimated by theOffice of Federal Housing Enterprise Oversight (OFHEO) for use in the proposed risk-basedcapital rule for the GSEs, as this is the loss severity assumption that the GSEs may be requiredto use in determining appropriate risk-based capital levels. OFHEO’s analysis of the lossseverity experienced by Freddie Mac from 1987 to 1995, considered to be a period ofextremely high losses, found average losses to be approximately 60 percent of the UPB.11 Atthis loss severity level and assuming very little of the original principal balance had been paid,Fannie Mae would bear 79 percent of losses under Loss Level I, 60 percent of losses underLoss Level II, and 51 percent of losses under Loss Level III. So under OFHEO’s extremeloss severity assumption, Fannie Mae would be expected to bear more than 50 percent oflosses under all three loss-sharing regimes. In contrast, if Fannie Mae’s reported experience

10 Fitch IBCA, Commercial Mortgage Stress Test Research. Structured Finance, Commercial Mortgage,

Special Report, October 23, 1998. Fitch IBCA and Duff & Phelps merged in June 2000, and the newcompany is now known as Fitch; however, research completed prior to the merger bears one of the twocompanies’ names and we have used this company name when referring to pre-merger research orpractices.

11 Office of Federal Housing Enterprise Oversight (OFHEO). “Risk-Based Capital Regulation: SecondNotice of Proposed Rulemaking,” Federal Register 64:70 (April 13, 1999), pp. 18083-18300.


of losses in the 25 to 30 percent range is assumed, lenders would bear less than 50 percent oflosses only under the loss sharing provisions of Loss Level I.12

In short, the share of losses borne by Fannie Mae depends on the severity of the loss. TheDUS product is analogous to mortgage insurance for single family loans in that, when lossseverity is low, the GSEs do not bear any losses and lenders could bear all of the losses at allLoss Levels. If loss severity is very high, Fannie Mae bears the majority of losses under allloss-sharing arrangements. This loss-sharing structure provides lenders with an incentive tocarefully underwrite loans during origination and then be proactive in servicing loans to avoidor minimize losses. To a certain extent, lenders may avoid many of the top-layer losses forwhich they are responsible by taking the appropriate steps during origination and servicing.At the same time, lenders are protected from the large losses that are likely beyond theircontrol, such as those due to a severe economic downturn, and that they are ill equipped tobear. Therefore, although Fannie Mae takes less than 50 percent of the expected loss whenloss severity is low, under every loss-sharing arrangement, they take more than 50 percent ofthe loss under high loss severity, which the lender is least capable of bearing and which isbeyond the lender’s control.

Negotiated Transactions

Fannie Mae’s Negotiated Transactions products are designed to provide liquidity for sellers ofmultifamily mortgage portfolios. The primary products include negotiated MBS, Real EstateMortgage Investment Conduit (REMIC)13 securities, credit facilities, and credit enhancementsprovided by Fannie Mae for taxable or tax-exempt bonds. These products accounted for over$6 billion in multifamily transactions in 1998. According to Fannie Mae officials, in recentyears, individual negotiated transactions have ranged from $30-$40 million to more than $1billion. The average negotiated transaction in 1999 was approximately $78 million. Thenegotiated MBS, REMIC securities and most credit facilities require the use of lender-provided credit enhancements.

Negotiated MBS SwapUnder an MBS swap, sellers such as banks, thrifts, and life insurance companies swap theirmultifamily mortgages for MBS, which can either be sold or used as collateral. The MBS isguaranteed by Fannie Mae and has an implied triple-A rating. The highly favorable risk

12 If the risk faced by Fannie Mae that lenders may be unable to meet their risk-sharing obligations

(counterparty risk) is also taken into account, then the expected share of losses borne by Fannie Mae ishigher.

13 REMICs were created by a provision of the Tax Reform Act of 1986 allowing the issuance of multiclasspass-through securities, or REMICs, which are nontaxable entities. By electing REMIC status, issuers canactively manage the cash flows related to a pool of underlying mortgages without negative taxconsequences.


classification of agency securities is due in no small part to the implicit guarantee of thesesecurities by the Federal government. The MBS provides the seller with liquidity because,with Fannie Mae’s guarantee, it is easier to sell and commands a higher price in themarketplace than whole loans. The MBS may also provide the seller with some capital relief.Sellers holding whole loans face a full risk-based capital charge, while lenders who swapwhole loans for MBS are required to hold only the capital related to the amount of recoursethey provide. This recourse is discussed in detail below.

Negotiated MBS Swap Credit EnhancementsBecause most swap transactions involve pools of mortgages that Fannie Mae does not re-underwrite, the seller is generally required to provide first-loss coverage for the mortgages.To determine the amount of first-loss coverage, or recourse, which the seller is required toprovide, Fannie Mae examines the quality of the loans in the pool. Recourse generally rangesfrom 4 to 25 percent of the pool size. It is important to note that recourse for a pool of loanscovers first losses on the entire pool up to the amount of recourse pledged. The lender thuscovers all of the losses associated with any loan default until the recourse is exhausted for thepool. After the recourse is exhausted, Fannie Mae is responsible for all losses. The seller isgenerally required to provide recourse over the entire life of the pool, but in some cases,“burn-off” provisions reduce the amount of recourse the seller is required to provide overtime.

Recourse is usually in one of the following forms:

• Letter of credit: A guarantee by a third party, typically a commercial bank, tocover losses due to default or foreclosure.

• Cash collateral account: A type of reserve account financed by a lender. Thereserve account is established with cash and/or a portion of the MBS issued in aparticular transaction. Cash and proceeds of the MBS are usually invested inhighly rated short-term instruments.

• Credit risk insurance: An insurance policy that covers losses on a mortgage poolup to the dollar amount of the recourse obligation.

• Corporate guarantee: A guarantee by the seller of the loans or an affiliate of theseller to cover losses due to delinquencies and foreclosures up to the recourseamount.

Fannie Mae officials report that the most common ways of satisfying a recourse obligation innegotiated transactions are, in order of frequency of use: corporate guarantee, letter of credit,cash collateral accounts, and pool insurance. Only institutions judged to be sufficiently credit


worthy (generally those A-rated or better) are eligible to provide a corporate guarantee in lieuof collateral to complete an MBS transaction.

On occasion, the seller elects to provide full recourse in a negotiated transaction. Fannie Maesaid that this is an unusual execution; however, if a seller’s only goal is liquidity then fullrecourse may meet its needs. In some cases, a seller may want to sell seasoned loans forwhich little operating and other data are available. In this case, the seller may not be able tosell the loans to Fannie Mae without providing full recourse.

REMIC StructureA REMIC is a multiple-class mortgage cash-flow security backed by whole mortgage loans orMBS. Cash flows generated by the mortgages or MBS are structured, or divided into classes,to create separately traded securities, which may be of varying risk and maturity. Seniorbonds that are guaranteed by Fannie Mae are issued and can be sold to third party investors orto Fannie Mae’s portfolio. In certain transactions, Fannie Mae also issues subordinate bondsthat are not guaranteed by Fannie Mae and that are equal to Fannie Mae’s required first losscoverage (or subordination) on the portfolio of multifamily mortgage loans. In this case, thesubordinate bonds provide the collateral for the lender’s recourse obligation; no additionalrecourse or collateral is required. The senior bonds have an implied triple A rating; thesubordinate bonds are issued as part of Fannie Mae’s Wisconsin Avenue Security (WAS) andare not rated. Under a WAS REMIC structure, all payments generally are first applied to thesenior security; losses are borne by the subordinate security.

Holders of multifamily mortgages that exchange their loans for Fannie Mae WAS REMICsmay get relief from risk-based capital requirements because the risk of loss is transferred to athird party through sale of the subordinate securities. Because the market for subordinate, orB, pieces is not very liquid, however, the sellers may have to hold the B pieces themselves. Inthis case, the seller may have to hold risk-based capital on this portion of the security. Theseller is providing the credit enhancement by owning a subordinate security that will absorb alllosses until the subordinate security is reduced to zero.

REMIC Credit EnhancementsFannie Mae determines the degree of loss protection, or the size of subordinate bondsrequired. The subordination level is a function of the characteristics of the loan pool,including such factors as loan-to-value ratios (LTV), debt service coverage ratios (DSCR),the degree of due diligence available on the properties, their geographic distribution, andrecent payment histories.

While information on the degree of credit enhancement required by the GSEs under differentcircumstances is not available, an informal survey of the REMIC prospectus supplements onFannie Mae’s web site gave an indication of the typical size of subordination required. All


REMICs from 1996 to 1999 inclusive that were indicated to be multifamily (such as 1999-M7) were reviewed. Of 28 multifamily prospectus supplements listed on Fannie Mae’s website, 16 consisted of pools of FHA-insured loans whose primary credit enhancement is FHAinsurance rather than a senior/subordinate structure. In four of the REMICs, the primarycredit enhancement was a senior/subordinate structure. The size of the subordinate portion ofthe security in these REMICs ranged from 2.47 percent to 9.5 percent of the total unpaidprincipal balance of the loans included in the REMIC.

Aggregation FacilityFannie Mae’s Multifamily Aggregation Facility was originally intended to work as amultifamily conduit. DUS and approved Aggregation Facility lenders can sell both singlenewly originated loans and portfolios of seasoned loans to Fannie Mae for cash. Fannie Maewould aggregate these loan sales into a loan pool with the intention of creating an MBSbacked by this loan pool. As with non-agency conduits, loans sold through the AggregationFacility are sold without lender recourse. No loss sharing or recourse is required. Once loansare deposited in the Aggregation Facility, Fannie Mae may purchase credit risk insurance on apool of loans that covers the first loss. The insurance is priced and sized based on anticipatedlosses, which are a function primarily of the quality of loans in the pool as well as thecharacteristics of the pool itself. While Fannie Mae initially aggregated the loans andsecuritized them as WAS REMICs, subsequently, Fannie Mae has held them in portfolio.

Volume in the Aggregation Facility has been small to date, which Fannie Mae reports may bethe result of more competitive pricing offered through non-agency commercial mortgage-backed securities (CMBS). Fannie Mae said that although some non-DUS lenders have beenapproved to participate in the Aggregation Facility product, none have done so. Instead,these lenders are selling their loans to conduits or Freddie Mac on a non-recourse basis.Although underwriting standards under the Aggregation Facility are the same as for DUS,Fannie Mae’s pre-review of these loans often permits greater underwriting flexibility for thisproduct.

One lender we spoke with said that Aggregation Facility pricing is currently unattractivebecause of the interest rate risk faced during the holding, or warehousing, period, before theloans can be securitized. To cover the interest rate risk, the rate to the borrower would haveto include a large spread. Although conduits face the same risk, their larger volume allowsthem to securitize loans more quickly, shortening the period during which they are exposed tointerest rate risk. This reduces potential losses and thus the spread conduits require ofborrowers to cover this risk.


Small Multifamily Loans

Fannie Mae has purchased a relatively small volume of small multifamily loans to date forseveral reasons. Fannie Mae officials said that because of the high fixed costs of underwriting,small multifamily loans have not typically been originated under the DUS product. Anotherimpediment to acquiring small loans is that most of the multifamily MBS Fannie Mae issuesunder the DUS product are backed by a single loan. Fannie Mae officials said that a $3 millionloan is widely acceptable in the market and can be securitized efficiently, and a $2 million loancan be securitized with reasonable efficiency; while loans under $1 million can be difficult tosell. As a result, most of the small loans Fannie Mae has acquired have been throughnegotiated transactions.

5-50 Product DescriptionFannie Mae introduced the 5-50 Streamlined Mortgage for small multifamily properties as apermanent product in May 2000 in order to increase purchases of small multifamily loansthrough the DUS product. The product is designed to reduce the cost and time to financesmall multifamily properties of five to 50 apartment units. As described above, the majority ofFannie Mae’s small multifamily loans are currently acquired through pool purchases(negotiated transactions). Because the volume of small multifamily loans through negotiatedtransactions can be highly variable, Fannie Mae officials believe that the 5-50 product couldbring in more business through DUS, giving Fannie Mae a more steady flow of small loanbusiness. Under the 5-50 product, Fannie Mae will purchase loans using a cash, MBS, oraggregation execution.

Fannie Mae reports that benefits of the 5-50 Streamlined Mortgage include reducedtransaction costs for third-party reports (under $4,000); reduced out-of-pocket costs to theborrower; streamlined underwriting requirements; simplified business processes; and reduceddata submission requirements. As of September 2000, Fannie Mae said the average 5-50 loanwas about $750,000.

The 5-50 Streamlined Mortgage is available to borrowers through Fannie Mae's DUS lendernetwork, 21 of whom are now approved 5-50 lenders. Fannie Mae officials said they mayconsider offering the product to lenders who are approved to originate loans through theAggregation Facility who are not also DUS lenders, but they have no specific plans to do this.

5-50 Product Credit EnhancementsAs in Fannie Mae’s original DUS product, under the 5-50 product, Fannie Mae delegates thesourcing, underwriting, commitment, closing and servicing to the DUS lender. As with allDUS loans, the lender must enter into a loss-sharing agreement with Fannie Mae. Fannie Maestated that loans originated through the product are no more likely to have higher risk-sharingrequirements (for example, Level II instead of Level I) than larger loans.


Freddie Mac Multifamily

Freddie Mac generally makes limited use of credit enhancements in its multifamily transactionsand therefore assumes full risk on a large share of the multifamily mortgages it purchases. Itobtains multifamily mortgages through two primary channels: its Program Plus network oflenders for loan-by-loan or “flow” business purchases, and through negotiated transactions forpurchases of individual loans and pools of loans. In addition, Freddie Mac purchases AAA-and AA-rated CMBS containing an average of 30 percent of multifamily volume.

In 1999, Freddie Mac financed $7.8 billion in multifamily housing. Most of this, $5.6 billion,went through its “cash” permanent financing products, while $1.5 billion of the total consistedof negotiated transaction executions and $244 million were direct investments in housing taxcredits.14

Program Plus

Freddie Mac introduced the Program Plus network of originators and servicers in 1993. Incontrast to Fannie Mae’s DUS product, Freddie Mac does not delegate underwriting to itsProgram Plus lenders under its Conventional Cash Purchases, but rather underwrites each loanitself. As a result, it does not require lenders to provide credit enhancements. Loans in thelarge loan component under the Conventional Cash Purchase product must be at least $1million and can have terms of five, seven, 10, 15, 20, 25, or 30 years. The Cash product alsoprovides for the purchase of smaller loans with a minimum loan size of $300,000.

Through its network of Program Plus lenders, Freddie Mac offers a variety of products,including:

• Conventional fixed-rate mortgage financing for acquiring, refinancing, andmoderate rehab of apartments;

• Credit enhancements for fixed- or floating-rate multifamily housing bonds;

• Second mortgages on Freddie Mac first mortgages;

• Forward commitments; and

• London Inter Bank Offer Rate (LIBOR) ARMs.15

14 Foong, Keat, ‘Lenders Say Freddie Mac Will Go “Outside Box’ to Capture Biz,” Multi Housing News,

September 2000.

15 Ibid.


The cash product accounts for approximately 75 percent of whole loan purchases throughthree main products: fixed rate, LIBOR ARM, and tax-exempt bond forwards. Freddie Mac’sfixed rate product accounts for two-thirds of its business. Only investment-grade multifamilyproperty can be used for collateral, and the loan must have a minimum DSCR of 125 and LTVof 80 percent. The LIBOR ARM product is used by lenders to manage the risk of defaultrelated to the movement of interest rates. Through the forward commitment product lineintroduced in 2000, Freddie Mac provides permanent financing to build or substantiallyrehabilitate garden or mid-rise apartments with either tax-exempt bond financing or low-income housing tax credits.

Program Plus Credit EnhancementsAs previously mentioned, Freddie Mac underwrites each loan purchased from Program Plusoriginators and therefore does not require seller-provided credit enhancements. Loanspurchased through the fixed rate product are non-recourse with respect to the seller. Theloans are also non-recourse with respect to borrowers, except for fraud and environmentalrisk.

Cross-collateralization and cross default are used in about half of all cash transactionsinvolving pools of only a few loans, which Freddie Mac officials report are not very common.When cross-collateralization is used, a loss on one property is secured by another propertyoriginated to the same borrower. Cross-collateralization provides limited credit enhancementin that it does not protect Freddie Mac from losses suffered at the pool level; it may onlyenhance a few properties in a pool of mortgages or multiple properties under commonownership financed with Freddie Mac proceeds.

In cross default, if one property fails, then the servicer may accelerate the entire principalamount under any of the mortgages and may foreclose on any or all of the mortgagedproperties owned by that borrower. These credit enhancements deprive the borrower of theoption to selectively default, and give the lender or investor the benefit of diversification. Theuse of cross-collateralization and cross-default lowers the guarantee fee Freddie Mac requires.

The only Program Plus product where credit enhancements are regularly used is the forwardcommitment product, which offers two executions: low-income housing tax credits or tax-exempt bonds.16 In this product, Freddie Mac requires that borrowers provide some type ofshort-term credit enhancement to offset short-term operating or cash-flow risk. For example,short-term credit enhancements are used to fund a loan before stabilized operating levels arereached. This type of credit enhancement is released when three criteria are met: theconstruction is completed in accordance with plans and specifications; the building is at 90

16 The purchase volume in the forward commitment product was $49.1 million in 2000.


percent occupancy for 90 days; and the debt service coverage ratio requirement is met. Atthis point, the construction loan is converted to a permanent loan.17 Three types of short-termcredit enhancements are used. First, Freddie Mac may require that a letter of credit from anacceptable bank (one with an A rating or better) be issued for 100 percent of exposure.Second, Freddie Mac may hold back a share of the loan, for example, hold 50 percent of theloan in escrow. Third, the borrower may issue a personal guarantee. According to FreddieMac officials, Freddie Mac has never had to draw upon one of these credit enhancements.

Negotiated Transactions

Through Freddie Mac’s Multifamily Negotiated Transaction product, lenders can securitizetheir multifamily portfolio mortgages into Gold Participation Certificates (PCs), which arepassthrough mortgage-backed securities, or Gold REMICs. Loans must be investment qualitywith loan amounts from $300,000 to $50 million. The minimum pool size is generally $100million, although smaller deals are considered. Sellers are not required to be Program Plusparticipants. Structured transactions, which are a specific type of negotiated transaction inwhich cash flows are divided into securities of varying investment quality and/or maturity, areused primarily for pools of seasoned loans and/or loans with a lower level of investmentquality. In 1999, there were $1.5 billion in negotiated transactions.

Negotiated Transactions Credit EnhancementsUnlike Freddie Mac’s Cash product, negotiated transactions generally entail some kind of firstloss coverage or collateral requirements. These credit enhancements are not required;however, borrowers can elect to use credit enhancement in order to either lower transactioncosts or improve the overall quality of the pool, thus permitting lower-quality loans to beincluded as part of the security interests for the transaction.

Two primary types of credit enhancement are used in negotiated transactions. First,borrowers may provide cross-collateralization for non-seasoned pools if the ownershipstructure of the pool of mortgages lends itself to this type of credit enhancement. If themortgages are not under common ownership, cross-collateralization generally cannot be used.Cross-collateralization is used when not all loans in the pool fit the parameters of the productbut the pool does on average. In some cases, cross-collateralization allows Freddie Mac tocomplete a transaction they otherwise would not do because some loans do not meet FreddieMac’s requirements. Sellers may provide cross-collateralization for seasoned pools; theborrower does not provide credit enhancements for these pools because the loans are closed.

Third-party credit enhancement is also sometimes used, generally in pools involving manyloans with small balances. The guarantee fee would be expensive without the credit

17 www.freddiemac.com/multifamily/lowincome.htm


enhancement because Freddie Mac inspects all multifamily properties, and the cost ofunderwriting these loans is high. Very infrequently, the seller provides the credit enhancementthrough recourse; more commonly, the borrower gives recourse if the borrower iscreditworthy, for example a real estate investment trust. Freddie Mac officials stated that in1999, one out of eight negotiated transactions completed involved third-party recourse.

Single Family

The GSEs make use of credit enhancements for single family mortgages for two basic reasons:first, to share and manage credit risk, and second, to satisfy their charter requirements. Wherethe charter requirement applies, the GSEs and lenders select a credit enhancement from astatutorily defined list of three structural options. The GSEs seek to have these charter-compliant credit enhancements serve both the compliance and risk management objectives.Where the charter requirement does not apply, or where it has already been satisfied, theGSEs and lenders are free to select from a longer and growing list of credit enhancementoptions. Fannie Mae indicates that to date, the bulk of its credit enhancements serve bothcharter compliance and risk management goals.

GSE Charter Requirements

The GSEs’ charters require credit enhancement in any single-family mortgage with an LTV atthe time the mortgage is purchased by the GSE of more than 80 percent. Specifically, threecredit enhancement options are available to the GSEs to meet this requirement: participation,repurchase agreements, and mortgage insurance.18 Credit enhancements used in addition tothose listed in their charters include pool insurance and subordination in a structuredtransaction.

By far the most significant credit enhancement used to meet the GSEs’ charter requirement isprimary mortgage insurance. Fannie Mae officials said that as of year-end 1999approximately 30 percent of their MBS and whole loans were covered by mortgage insurance.Freddie Mac appears to make somewhat less use of mortgage insurance than Fannie Mae.According to Freddie Mac’s 1999 Annual Report, 30 percent of the corporation’s totalmortgage portfolio was credit enhanced as of year-end 1999, and pool insurance was the mostprevalent type of credit enhancement. In order to satisfy the charter requirement, mortgageinsurance must cover that percentage of the UPB in excess of 80 percent of the value of thehome at the time the loan is acquired by the GSE on each mortgage.

18 National Housing Act, Title III, National Mortgage Associations, Section 302(b)(2) [12

U.S.C.1717(b)(2)]; Federal Home Loan Mortgage Corporation Act, Section 305(a)(2) [12 U.S.C.1454(a)(2)].


In practice, the GSEs generally benefit from mortgage insurance substantially in excess of thatminimum amount. Coverage amounts for mortgage insurance are defined as a specifiedpercentage of the claim amount (equal to the default UPB plus accrued interest plus allowablecosts). As of year-end 1999, the weighted average mortgage insurance coverage was about 25percent of the claim amount in the event of default according to Fannie Mae. However, theactual coverage depends on the LTV at origination and the amount of insurance purchased. AMay 2000 rate plan from GE Mortgage Insurance shows that, depending on the insuranceoption selected, coverage ranges from 18 to 35 percent for loans with LTVs over 90 percent,and from 12 to 35 percent for LTVs between 85 and 90 percent.19

Until recently, the GSEs had a single standard of mortgage insurance for each LTV category.These standard levels were approximately twice the minimum coverage required in the GSEs’charters, reflecting the dual goals of risk management and compliance. As credit riskmanagement technologies (such as automated underwriting systems) improved and enabledlenders and the GSEs to discern important differences in risk beyond LTV (e.g., creditstrength, reserves, etc.), the GSEs began to offer lenders an array of mortgage insurancecoverage options increasingly tailored to the risk of each mortgage. In every case, the amountof mortgage insurance exceeds the minimum specified in the charter.

The lowest rates available are “reduced coverage rates.” For 95 and 97 percent LTV loans,coverage rates of as low as 18 percent are available for loans that receive a certainclassification from the GSEs’ automated underwriting systems. Automated underwritingsystems are designed to enable lenders and the GSEs to more accurately evaluate the risk of aloan than manual underwriting. For 90 percent LTV loans, a coverage rate of as low as 12percent is available; this is not necessarily related to the classification given the loan by theautomated underwriting system.20

Although primary mortgage insurance reduces the severity of loss due to mortgage default,Fannie Mae and Freddie Mac hold the risk of certain losses. The GSEs are responsible forany losses that exceed those covered by the mortgage insurance policy. In a severe localmarket downturn, for example, very little of the value of the house may be recoverablethrough resale. In addition, costs of default, which include the legal costs associated withforeclosure, accrued interest, and the costs of maintaining the house before it is sold, canescalate rapidly if the house does not sell quickly or is in poor condition.

In addition to the deep loss layer not covered by mortgage insurance, the GSEs areresponsible for all losses (net of any credit enhancement other than mortgage insurance) in theevent that mortgage insurers default on their obligations. In a catastrophic scenario,

19 GE Capital Mortgage Insurance rate sheet.

20 Ibid.


OFHEO’s risk-based capital rule discounts the ability of counterparties to meet theirobligations – or gives it a “haircut” – to reflect the expected level of risk associated with thosefirms under stressful market conditions. The magnitude of the haircut varies with the creditrating of the counterparty. To manage this counterparty risk, Freddie Mac monitors thecapital adequacy of the mortgage insurance companies that it does business with. The GSEs’charters state that the guarantee must be provided by a qualified insurer as determined by thecorporation.21 Fannie Mae and Freddie Mac have somewhat different eligibility standards formortgage insurance companies, but in general both require mortgage insurers to maintain acredit rating of AA or better.

For both GSEs, the trend is toward a declining use of standardized, one-size-fits-all mortgageinsurance. Fannie Mae officials said that mortgage insurance alone may not always be the bestand most efficient way to manage and share risk for several reasons. First the level ofmortgage insurance required is based on only one risk factor – LTV at origination. Second,the process of loss mitigation can be inefficient because both Fannie Mae and the mortgageinsurer have an interest in the outcome and there is substantial duplicative work andbureaucratic waste in coordinating activities. Third, some borrowers are over-insured becausethe mortgage insurance coverage purchased is greater than the average loss. In essence, someborrowers are paying for excess mortgage insurance. In addition, recent legislation allowsborrowers to cancel their mortgage insurance when the LTV of their mortgage drops to acertain level, reducing the length of time over which mortgage insurance is available to coverlosses.

Freddie Mac has started to make use of custom mortgage insurance, under which lenders havethe option to reduce the level of mortgage insurance coverage to the minimum required tomeet Freddie Mac’s charter requirements. Depending upon the circumstances, the same or ahigher loan delivery fee may be charged. The increased credit risk delivered to Freddie Mac iscurrently not transferred to other parties through the purchase of insurance or some othercredit enhancement; rather, Freddie Mac is holding and managing the additional credit riskthemselves.

Under a repurchase agreement, the seller must, for such period and under suchcircumstances as the GSE requires, repurchase or replace a mortgage in the event that themortgage is in default, regardless of the reason for default. Using this credit enhancement,lenders retain some or all of the credit risk, depending upon the period and circumstancesunder which the GSE requires repurchase. This is a rarely used option, apparently becauserisk-based capital standards require lenders to hold full capital for loans sold under such anagreement. Fannie Mae estimated that less than 3 percent of their loans are covered by full

21 Op. cit., fn18.


recourse, and most of these were originated several years ago. Freddie Mac also reported thatthis is an infrequently used form of credit enhancement.

In the last credit enhancement option available to the GSEs under their charters, the sellerretains a participation of not less than 10 percent in the mortgage. This means that thelender maintains a 10 percent stake in a loan sold to a GSE. Freddie Mac officials said thatthis option is unpopular with lenders because of the bookkeeping burden associated withtracking pieces of loans and the regulatory capital requirements associated with retained loanparticipations. In addition, participation did not have the intended effect of ensuring that loansoriginated by lenders were high quality and left Freddie Mac exposed to 90 percent of the risk.Both Fannie Mae and Freddie Mac officials said this option is virtually never used.

Other Forms of Credit Enhancement

Another important credit enhancement for both GSEs is pool insurance. Pool insuranceprovides coverage to a pool of loans at an aggregate level. In general, pool insuranceproviders cover all losses on a pool up to a stop-loss level, typically 1 percent of losses to thepool. Fannie Mae officials said that the primary motivation for lenders to purchase poolinsurance is to get a better price from Fannie Mae for their pool of mortgages. Fannie Maeand Freddie Mac also purchase pool insurance to meet their credit risk managementobjectives.

Freddie Mac estimates that over the last few years, 20 to 25 percent of flow production iscovered by pool insurance, most of this loans with LTVs over 65 percent. According toFannie Mae, approximately 13 percent of loans are covered by pool insurance, of which abouthalf are also covered by primary mortgage insurance. In our interviews we were told that thepurchase of this kind of credit enhancement by lenders has declined because of recentincreases in the capital requirements required to maintain a minimum AA rating for mortgageinsurers who provide pool insurance. However, pool insurance remains popular amonglenders and the GSEs for structured transactions, special risk types and other purposes.

Both GSEs reported that spread accounts are not commonly used, other than in structuredtransactions. Spread accounts, a form of credit enhancement sometimes used by non-agencyissuers as well, are accounts used to capture the excess cash flow over the interest due to theinvestor and servicing fees. These funds are used to cover losses from mortgage default asthey occur. Spread accounts are not generally used by the GSEs for several reasons. First,spread accounts are not one of the options specifically listed in the GSEs’ charters for meetingcredit enhancement requirements. Freddie Mac reported that spread accounts are never usedfor loans with LTVs above 80 percent. Second, lenders and the GSEs find spread accounts tobe capital intensive and therefore expensive. Freddie Mac officials said that in a stress testscenario, spread accounts tend to be wiped out quickly and therefore result in relatively high


capital requirements. Last, on fixed-rate loans, the margin is generally too thin to fund aspread account.

A tiered primary policy is a type of credit enhancement that Freddie Mac mentioned using.Although Fannie Mae did not discuss tiered primary policies with us, PMI Group, a mortgageinsurer, disclosed both GSEs’ announcements of the credit enhancement in its quarterlyreport.22 Under a tiered primary policy, borrower-paid mortgage insurance is restructured tobetter meet the GSEs’ anticipated capital requirements from OFHEO. Tiered primary policiesdo not appear to be a significant credit enhancement in terms of current volume of business;however, Freddie Mac officials said they thought that tiered primary policies might replacepool insurance in the future to some extent.

According to Freddie Mac officials, after the credit enhancements required by its charter, themost important other form of credit enhancement used is subordination in a structuredtransaction, described below. Fannie Mae described credit enhancements such as structuredrecourse, securitization using a senior/subordinated structure, credit derivatives, andreinsurance as not being important forms of credit enhancement for their business; however,they said they were beginning to use some of these tools. For example, Fannie Mae’sWisconsin Avenue Securities use a senior/subordinated structure.

Negotiated transactions, also called structured transactions, are used for purchases ofseasoned loans and for subprime business. When subordination in a structured transaction isused, portfolios of loans are separated, or “structured” into senior and subordinate securities.Freddie Mac sometimes purchases the senior securities. The subordinate security providescredit enhancement to the senior security by taking losses that occur in the entire pool. Thesenior security does not incur losses until there is nothing left in the subordinate piece toabsorb losses. In 1998, about 30 percent of all agency residential mortgage-backed securities(RMBS) (including MBS issued by Ginnie Mae) were REMICs.23

Freddie Mac officials said that depository institutions often sell portfolios of seasoned loans toFreddie Mac through negotiated transactions. They may do this to meet their liquidity goals,capital requirements, or other needs. The credit enhancement that is required, or the size ofthe subordinate security, is dictated primarily by the type and quality of loans in the portfolio.For example, Freddie Mac officials said that a larger subordinate security is required onunusual products like negative amortization COFI (Cost-of-Funds Index) ARMs. Subprimeloans are also more likely to have greater levels of credit enhancement than conventionalmortgages. There is less standardization in these mortgages and their risks are harder toevaluate, because the data Freddie Mac receives on the mortgages is heterogeneous. Freddie 22 August 11, 2000, PMI Group Inc Quarterly Report, SEC form 10-Q.

23 Hu, Joseph, The Evolution of Residential Mortgage-Backed Securities, Standard and Poor’s, March 2000.


Mac also has less experience with subprime loans than with prime loans, and thereforerequires that a greater level of comfort be provided through credit enhancement.

CRA Loans

The GSEs’ charters can present obstacles in their purchases of loans originated as part oftargeted affordable mortgage products developed to comply with the CommunityReinvestment Act (CRA). These loan products generally feature flexible underwritingstandards, below-market interest rates, and often do not require mortgage insurance. As aresult of the flexible underwriting standards and the wealth constraints on low-incomeborrowers, the loans often have high LTVs. Because they are not covered by mortgageinsurance, the GSEs’ charters prevent them from purchasing these high LTV loans.

Because of their charter restrictions, both Fannie Mae and Freddie Mac are working to comeup with alternative strategies for purchasing CRA loans. Most of Freddie Mac’s CRA loans,for example, are seasoned loans purchased through negotiated transactions. However, as anadditional challenge to purchasing CRA loans, lenders are sometimes reluctant to sell CRAloans because their below-market interest rates mean that a seller will take a book loss on theloan unless interest rates have fallen since the loans were originated. According to FreddieMac, most CRA purchases are therefore made during periods of falling interest rates.

Because these loans are not covered by mortgage insurance, alternative forms of creditenhancement are required. For example, the GSEs can purchase or guarantee the senior pieceof a structured transaction because subordinate certificate holders provide credit enhancementby assuming the majority of the credit risks associated with the underlying mortgages.According to a study conducted by the Urban Institute, CRA REMICs provide an acceptableprice to sellers when the coupon rates for targeted affordable loans are at least 75 basis pointsabove market rates for 30-year fixed rate mortgages that conform to the GSEs’ underwritingstandards.24

24 Temkin, Kenneth, Jennifer Johnson, Charles Calhoun, An Assessment of Recent Innovations in the

Secondary Market for Low- and Moderate-Income Lending, Urban Institute, March 2000.


3. Non-GSE Use of Credit Enhancements25

This chapter describes the findings of our interviews and research conducted on the use ofcredit enhancements by secondary market participants other than Fannie Mae and FreddieMac. The chapter begins with an in-depth review of the Federal Home Loan Banks’ (FHLB)Mortgage Partnership Finance (MPF) program. This program, and the closely relatedMortgage Purchase Program (MPP), provide an innovative new approach to sharing creditrisk of single-family loans among loan originators, mortgage insurers and the FHLBs. Thesecond part of the chapter then describes the use of credit enhancements in non-agency single-family and multifamily transactions.

Federal Home Loan Bank Mortgage Partnership Finance Program

For decades depository institutions, which dominated single family originations in the first halfof the century, have been losing mortgage market share due mainly to the sweeping growth ofthe secondary market. Secondary market expansion by Fannie Mae and Freddie Mac enableda variety of new financial institutions to originate loans without having to hold them inportfolio, thus reducing depositories’ share of the originations market. Two programs havebeen designed by the Federal Home Loan Banks to address this issue: the MortgagePartnership Finance (MPF) Program and the Mortgage Purchase Program (MPP). In 1997the FHLB of Chicago developed the MPF program.26 The MPP, developed jointly by theFHLBs of Indianapolis, Seattle, and Cincinnati, is intended to serve a similar purpose.

In this section we will examine primarily the MPF program, which uses credit enhancements ina variety of ways. Because the program is an alternative to Fannie Mae and Freddie Mac forsome lenders, it is interesting to compare its use of credit enhancements with those used bythe secondary market agencies. The main finding of our review is that seller-provided creditenhancements have been a key component of the success of the MPF program.

Program Overview

The MPF program provides FHLB member institutions27 an alternative to their two historicaloptions for single family mortgages of either holding them in portfolio or selling them to

25 Throughout the paper, the term GSE is used to refer only to Fannie Mae and Freddie Mac, although there

are other GSEs.

26 www.bankinfo.com, April 10, 2000, “Mortgage Partnership Finance Provides a New Way Home,”reprinted with permission from CCH Focus on Banking, Serena Lynn, ed.

27 Member institutions include all federally chartered and most state chartered thrift institutions, mostcommercial banks, and some credit unions and insurance companies.


Fannie Mae or Freddie Mac. MPF allows member institutions to sell either pooled mortgagesor those originated on a flow basis to an FHLB.28 Selling loans to Fannie Mae, Freddie Mac,or the FHLB relieves the member institution of interest rate risk (the risk of loss due tofluctuations in interest rates). Interest rate risk poses a significant threat to depositoryinstitutions – it was a major contributing factor to the savings and loan crisis of the 1980s –and as a result, many are reluctant to hold fixed-rate mortgages in portfolio. The GSEs(including the FHLBs) are better equipped to manage interest rate risk than most FHLBmember institutions because of their ability to raise low-cost, long-term funds in the capitalmarkets and their ability to manage interest rate risks more effectively.

In addition to allocating interest rate risk to the FHLB, the sale of a loan through the MPFprogram allocates a portion of the credit risk to the FHLB. The member institution effectivelyretains the first loss position on the credit risk, providing a credit enhancement on the pool.29

While the FHLB serves as a secondary market, it does not require a guarantee fee as doFannie Mae and Freddie Mac.30 This is because the FHLBs do not provide the same level ofdefault loss coverage as the GSEs on mortgages they purchase. Based on the pool’s creditquality, size, geographic diversity and other factors, the member institution may haveexposure to losses of 200 to 400 basis points of the pool value.31

To compensate members for retaining a portion of the credit risk, members earn a creditenhancement fee. This fee varies based on type of mortgage pool and the FHLB involved.Thus, rather than paying a guarantee fee to Fannie Mae or Freddie Mac, members retain aportion of the credit risk and are compensated by earning a credit enhancement fee. Thedownside to holding some of the credit risk is the exposure to risk-based capital requirements,which are discussed below.

28 Pools are composed of conventional or FHA mortgages with fixed-rates and terms up to 30 years on 1-4

family residential properties that are owner-occupied.

29 MPF requires members to credit enhance a mortgage pool to the equivalent of a AA credit rating.

30 Federal Home Loan Banks raise funds by selling consolidated obligations to institutional investors. As agovernment-sponsored enterprise and with their stand-alone AAA credit ratings, they can raise debt atrates only slightly higher than Treasury securities.

31 The precise level of credit enhancement is determined by a modeling analysis of the portfolio. Theestimated current average is 200 basis points but that is lower than expected, since early pools were lowerrisk due to the preponderance of low LTV refinancings in the pool.


MemberInstitution

MortgageInsurance

Borrower Equity

FHLB DeepLoss Layer

Exhibit 3: MPF Program

0%

100%In addition to the credit enhancement provided bythe member institution, loans with LTV ratios ofmore than 80 percent are also covered by mortgageinsurance. The FHLB bears risk in the event oflarge losses on the mortgage pools. The generalstructure of the MPF program at loan origination isshown in Exhibit 3.

Relief from Capital Requirements

An important aspect of the MPF program is thecapital relief it offers to member institutions. Risk-based capital requirements are based on the “BasleAgreement,” an international accord thatestablished common standards for capital adequacyof depository institutions. These standards wereadopted by the four federal agencies responsible forregulation of banks and thrift institutions inresponse to the Financial Institutions Reform, Recovery and Enforcement Act of 1989(FIRREA). Since FIRREA, institutions holding single-family mortgages are required to holdrisk-based capital equal to 4 percent of these assets. Furthermore, selling assets with recoursegenerally provides no capital relief – the member institution is still required to hold risk-basedcapital of 4 percent. However, the low-level recourse rule allows sellers with a recourseobligation amounting to less than 4 percent of the asset value to hold capital only to cover 100percent of that recourse obligation.

Various products offered through the MPF program have been developed to address thisissue. The MPF program employs recourse-like arrangements but with enough additionalcredit enhancements that member institutions are not required to hold the full 4 percent inrisk-based capital; instead, the low-level recourse rule applies.

MPF Products

The MPF program now has a number of variations that have been structured to offer memberinstitutions options in the types of credit enhancements that can be used, varying levels of riskexposure, and relief from capital requirements in varying ways. Originally, the MPF programoperated under only one structure. That structure is now known as MPF Classic. In additionto the MPF Classic, the most commonly used conventional MPF products are the MPF 100and the MPF 125+, described below. Another product that is available but that has not seenwidespread use is the MPF 125. This is similar to MPF 100, so the products are described inthe same section. A product through which FHA-insured mortgages are purchased by the


FHLB is also in widespread use; however, this product is not as relevant for the purposes ofthis study because the primary credit enhancement is the full mortgage insurance covered byFHA.

As in other areas of the single-family secondary mortgage market, the use of creditenhancement and the specific structure of deals done under the MPF program are rapidlychanging. The structures described under each MPF product below should thus be viewed asexamples of how the products can be used. In practice, specific deals negotiated may differfrom those described in unforeseen ways.

The amount of recourse promised by the member institution under the various MPF productsis not generally collateralized by a letter of credit, a corporate guarantee, or any other form ofinsurance. This is because of the statutory security agreements that exist between memberinstitutions and FHLBs that apply to all member institution obligations. This type ofagreement, also referred to as a super lien, gives the FHLB the first claim on a memberinstitution’s assets ahead of any other lien holder (on unsecured assets). Importantly, theFHLB can claim assets before the Federal Deposit Insurance Corporation. So FHLBs need toensure only that the institution has enough unpledged assets to cover the guarantee, making anadditional credit enhancement mechanism such as a letter of credit or a corporate guaranteeunnecessary.

MPF ClassicThe MPF Classic is the original structure under which the MPF program was launched.Loans originated by a member institution are closed in the name of the FHLB and thereforenever appear on the balance sheet of the member institution. The FHLB takes a portion ofincome from the loan and applies it to a spread account to be used to cover default losses.Typically, 4 basis points of income32 annually (as a percent of UPB) come out of cash flowsfrom the loan and into the spread account. Over the life of the pool, this annual fee caneventually add up to 25-35 basis points of the total pool amount.

The member institution provides the total level of credit enhancement required for the pool toreach AA-quality. The spread account does not count toward the member’s creditenhancement requirement. For example, the member institution may need to provide 300basis points of loss coverage for the pool to reach an AA rating. For providing this coverage,the member institution is paid a 9 to 11 basis point credit enhancement fee annually from thespread on the mortgage pool.

When losses occur, they are first covered by primary mortgage insurance (if the loan has anLTV greater than 80 percent), and then by the spread account. After the spread account is

32 Average loss experience has dictated that 4 basis points be charged.


MemberInstitution

to AA-RatingLevel

Spread Account

MortgageInsurance

Equity

FHLB DeepLoss Layer

Exhibit 4: MPF Classic

0%

100%

exhausted, the member covers losses up to the amount that they had provided to make theasset AA-quality. The FHLB covers losses beyond this amount.

The MPF Classic structure has disadvantages forsome institutions because of its risk-based capitaltreatment. The Office of Thrift Supervisionallowed member institutions using this structureto hold 8 percent risk-based capital against onlythe loss coverage required in order to make theasset AA-quality, far less than the capital thatmust be held for whole loans.33 Other regulators,however, did not allow this treatment, andrequired risk-based capital (4 percent) to be heldagainst the full UPB of the pool. This limited theusefulness of the program for some memberinstitutions. The loss-sharing layers in the MPFClassic product are shown in Exhibit 4.

MPF 100 and MPF 125The MPF 100 was created next, partly inresponse to the unfavorable capital treatment ofthe MPF Classic by some regulators. In this structure, the FHLB is responsible for 100 basispoints of any loss incurred on the pool beyond losses covered by mortgage insurance. As theFHLB’s compensation for covering the first 100 basis points of losses, the FHLB withholdspart of the credit enhancement fee that would otherwise be paid to the member, as describedbelow. The member institution is responsible for the loss coverage required for the pool to beAA-quality. This loss coverage is provided through a direct guarantee.

Under the MPF 100 program, 9 to 11 basis points are paid to the member as a creditenhancement fee, but after the first three years, this payment is contingent on the level oflosses experienced by the pool. If there are losses, these are first deducted from the creditenhancement fee. If losses incurred are greater than the credit enhancement fee, they areabsorbed by the FHLB. However, the member institution pays for these losses in that they arecarried forward and deducted from credit enhancement fees in future years. Thus losses arecovered first by primary mortgage insurance, then by the FHLB up to 100 basis points, thenby the member institution’s direct guarantee, and then the FHLB covers deep losses.

33 For example, if the loss coverage required is 300 basis points, then the Office of Thrift Supervision’s risk-

based capital requirement is 8 percent of this amount, or 24 basis points.


MemberInstitution

FHLB to 100Basis Points

MortgageInsurance

Equity

FHLB DeepLoss Layer

Exhibit 5: MPF 100

0%

100%Under the MPF 100 product, regulators agreedthat member institutions would have to holdonly 8 percent of their level of required creditenhancement in risk-based capital, substantiallyless than the 4 percent of total UPB requiredwhen whole loans are held.34 This favorablecapital treatment is only offered on loansoriginated in the name of the FHLB, or flowbusiness, not on FHLB purchases of seasonedpools. There is no capital advantage to usingMPF 100 for non-flow business. The loss-sharing layers used in the MPF 100 product areshown in Exhibit 5.

In the MPF 125 product, as in MPF 100, theFHLB covers the first 100 basis points of losses(beyond those covered by mortgage insurance).The FHLB recoups this coverage from a creditenhancement fee. The major difference between MPF 125 and MPF 100 is that the MPF 125program is open to bulk purchases.

MPF 125+As opposed to the MPF 100 where favorable capital treatment was given to flow business, theMPF 125+ was designed to give favorable capital treatment to pools of seasoned mortgages.In this structure, high quality pools are created so that the credit enhancements necessary areminimal.

Under MPF 125+, the member institution has the option of having a third party hold most ofthe credit risk through supplemental mortgage insurance. The FHLB will cover losses (afterthose covered by equity and mortgage insurance) approximately equal to expected losses onthe pool. The supplemental mortgage insurance covers a pre-determined number of basispoints and the remainder of losses are guaranteed by the member institution. The risk-basedcapital requirement for the member is the amount it guarantees.

For example, if an AA rating requires 3 percent credit enhancement, and the FHLB provides30 basis points of loss coverage, the member institution may acquire sufficient deep mortgage

34 Again, if the loss coverage required is 300 basis points, then the risk-based capital requirement is 8

percent of this amount, or 24 basis points.


SupplementalMortgage Insurance

FHLB’sExpectedLossCoverage

MortgageInsurance

Equity

MemberInstitution

FHLB

Exhibit 6: MPF 125+

<

0%

100%

insurance to provide 250 basis points of loss coverage, and the remaining 20 basis points isguaranteed by the member. The member is required only to hold 20 basis points of capital.

The calculation of loss coverage provided by supplemental mortgage insurance is notstraightforward, because coverage is provided at a loan, not a pool level. Pool insurancecovers a specified percentage of the losses on a large group of similar loans. Supplementalmortgage insurance is obtained for individual loans and thus covers loss only in the event thata loss is experienced on a particular loan.

Members are only allowed to use pool insurance to cover the portion of the required creditenhancement that is attributable to the pool’s small size or lack of geographic diversity. Thisexception generally applies to small member institutions that find it difficult to amasslarge/geographically diverse enough pools to achieve the desired rating.

Under MPF 125+, as in MPF Classic andMPF 100, 9 to 11 basis points go back tothe member as a credit enhancement fee;however, this payment is contingent onthe level of losses experienced by thepool. If there are losses, these are firstdeducted from the credit enhancement fee.Any losses greater than the creditenhancement fee are absorbed by theFHLB. These losses are carried forwardand deducted from credit enhancementfees in future years. The primarydifference between MPF 125+ and MPF100 is that under MPF 125+ memberinstitutions are allowed to purchasesupplemental mortgage insurance to coverpart of their portion of the loss coverage.The loss-sharing layers used in the MPF125+ product are shown in Exhibit 6.

Determining the Level of Credit Enhancement

Standard and Poor’s LEVELS (Loan Evaluation and Estimate of Loss System) model is usedto give an indication of the necessary level of credit enhancement to achieve an AA rating.35

35 Although pools of mortgages sold to the FHLB are not formally rated by a ratings agency, they are

“notionally rated” by the use of Standard and Poor’s rating software.


FHLBs are expected to re-rate pools on an ongoing basis. If the pool is not performing aswell as expected (i.e. it falls below an AA rating), then under the Federal Housing FinanceBoard’s (FHFB) regulations, the member institution must set aside retained earnings to coverthe additional capital that is then required to improve the pool to an AA rating.

Volume

The FHFB authorized the Federal Home Loan Bank of Chicago to use MPF as a pilotprogram in January 1997.36 After an examination of the program in June 1998, the FHFBauthorized all FHLBs to offer the program to their members, once each FHLB applied to be inthe program under terms and conditions laid out by the FHFB. As of May 2000, the FHFBhad MPF program applications or approvals from 9 of the 12 FHLBs and anticipates oneother will apply.37 In terms of volume, the FHLB of Chicago had a $750 million cap onmortgage pools purchased through MPF. In September 1998, that was changed to a cap of$9 billion for the entire FHLB system.38 By June 2000, the FHFB lifted the cap completely,and by the end of September 2000 MPF purchases exceeded $13 billion.39

MPP

As described above, the MPP is intended to serve a similar purpose for members as does theMPF Program. Three FHLBs will offer this product to members: the FHLBs of Indianapolis,Seattle, and Cincinnati. This program is still very new and thus hard to evaluate. In October2000, the FHFB approved purchase of conventional loans through the MPP; before then,participating FHLBs had approval only to purchase FHA-insured loans through the MPP. TheMPP is now being offered on a limited basis; the three Banks are subject to a temporary $300million cap each until FHFB staff can review the program after a few deals have beencompleted.

Four levels of credit enhancements are used in the MPP. First, like the MPF program,mortgages with greater than 80 percent LTV have private mortgage insurance. This is thefirst credit enhancement to absorb any losses due to defaults.

Second, when the FHLB buys a pool of loans from a member, the member is required to setaside additional funds (usually approximately 50 basis points of value of each loan) into a

36 Federal Housing Finance Board, “Mortgage Partnership Finance Program (MPF) Program

Modifications,” Press Release FHFB 98-33, September 23, 1998, p.1.

37 The remaining two FHLBs are pursuing MPP alone as an alternative to MPF.

38 Federal Housing Finance Board, “Finance Board Approves Expansions of Pilot Mortgage PartnershipFinance Program,” Press Release FHFB 98-33, September 23, 1998, p.1.

39 Sichelman, Lew, Realty Times, September 26, 2000.


lender risk account held by the Bank. If between years one and five there is a default andmortgage insurance funds to cover the loss are exhausted, then funds from the lender riskaccount are used. If after five years, there are no losses, then the FHLB will begin to transferthe accumulated value of the account back to the member (payments will be spread over theperiod of 10 years).

Third, after the lender risk account is exhausted, deep mortgage insurance is used to coverlosses typically down to 60 percent or less of the loan value. Last, the FHLB bears losses inthe case that all other credit enhancements are exhausted.

Other differences between the MPP and Chicago’s MPF Program are operational. The MPFis a consolidated program in which FHLB Chicago is in charge of operations and pricing. Inthe case of MPP, each FHLB runs the program individually. There are slight variations inoperations and pricing between Banks.

Non-agency Securities

Virtually all private-label or non-agency securities use some form of credit enhancement. TheGSEs rely less heavily on credit enhancements than non-agency issuers. Because of theircharters and their agency status, Freddie Mac and Fannie Mae securities are considered to beAAA rated, and provide high-quality corporate guarantees of the timely payment of theprincipal and interest on mortgage-backed securities. 40 The GSEs are thus in a position tohold some credit risk. In contrast, private-label issuers typically do not provide a corporateguarantee for their issues because they are not adequately capitalized to do so and because thecost of raising additional capital is high. To achieve AA and AAA rated securities, private-label issuers must provide additional credit enhancement. Some form of credit enhancement isvirtually always used in both commercial (CMBS) and residential (RMBS) issues, and themost common form used is the senior/subordinate structure. This credit enhancement as wellas other forms used are described below.

Residential Mortgage-Backed Securities

Private-label securities are often used to finance nonconforming mortgages, or those that aregenerally not purchased by the GSEs, primarily because of their size or poor credit quality.Most of the mortgages pooled to back private-label RMBS are prime mortgages, butnonconforming mortgages for borrowers with blemished credit history and/or second lien

40 The GSEs themselves are not necessarily AAA rated. An assessment of the risk that the government

would have to step in to meet Fannie Mae’s obligations was done by Standard and Poor’s in 1997. Thisassessment rated Fannie Mae as AA-. (National Mortgage News, January 8, 2001, p. 4.)


status have become increasingly important since the early 1990s.41 The primary issuers ofprivate-label RMBS are mortgage bankers, commercial banks, thrift institutions, and financecompanies.

Private-label RMBS have grown from $250 million in 1977 to more than $91 billion in 1999.This represented almost 11 percent of the total issuance of U.S. RMBS in 1999, which wasover $840 billion. Fannie Mae’s share of this total was almost 36 percent in 1999; FreddieMac’s share was 28 percent. The remainder of RMBS issuance in 1999 was accounted for byGinnie Mae (17.5 percent) and home equity loans (8 percent).42

In the first years of the private-label RMBS issuance, corporate guarantees, mortgage poolinsurance, bond insurance, and letters of credit were commonly used either individually or invarious combinations. In 1988, Standard and Poor’s assigned its first multiple credit rating toa single transaction, marking the beginning of the senior/subordinate cash flow structure.Because of its efficiency, by the early 1990s, the senior/subordinate structure became thesingle most important mechanism for credit enhancement, particularly for prime mortgages.43

Virtually all prime RMBS are now issued using a senior/subordinate structure. For subprimepools, however, bond insurance and corporate guarantees remain the predominant means ofcredit enhancement. Only recently have issuers begun to use senior/subordinate structures toenhance significant subprime pools.

Sizing Subordination LevelsEach ratings agency has its own model for determining the size of subordination necessary toobtain a particular rating, or to assign a rating based on a particular transaction structure. Ingeneral, the credit enhancement required for a mortgage is calculated by multiplying thelikelihood of loss-producing default (loss incidence) for the mortgage by its loss severity. Thecredit enhancement required for a pool is then the sum of the enhancement required for eachmortgage with adjustments for pool characteristics.

Loan characteristics used to determine loss incidence and loss severity include LTV, type andterm of the mortgage, principal balance, the type of mortgaged property, the guidelines usedin approving the mortgage, and the quality of the borrower. Increasingly, FICO scores areused to determine the credit risk of a borrower.

For example, Standard and Poor’s LEVELS model analyzes a loan or pool of loans andassigns one of 10 Risk Grades along with the foreclosure frequency, loss severity, and credit


42 Performance of U.S. RMBS Credit Ratings, 1978-1999, Standard and Poor’s.



enhancements required for securitization.44 In the LEVELS model, increased creditenhancement is required for mortgage pools with less than 300 loans. This is called the “poolsize factor.” Another adjustment is made based on the “geographic factor” – increased creditenhancement is required for a pool in which more than 5 percent of loans are located in onezip code. In addition, the size of subordination varies based on the cash flow structure. Forexample, the size of subordination required may be reduced for senior/subordinate structurethat also uses over-collateralization with a spread account versus a straight senior/subordinatestructure.45

Commercial Mortgage-Backed Securities

CMBS are typically collateralized by a mixture of various kinds of commercial real estate,including multifamily, retail, hotel, industrial, and office. CMBS are usually secured by loansto multiple borrowers and on multiple properties. Two other major transaction structures arealso used: single-borrower, multi-property; and single-borrower, single-asset.

Private-label CMBS were first issued in the late 1970s; however, the issuance of CMBS didnot become common until the early 1990s. At that time, CMBS were being issued primarilyby the Resolution Trust Corporation, to dispose of commercial mortgages acquired fromfailed savings and loan institutions. Beginning in the mid-1990s, commercial mortgage loansbegan to be originated with the intent of being securitized and the conduit-CMBS marketemerged. In a conduit transaction, the conduit provides a source of capital to commercial realestate borrowers. Conduits originate and hold commercial mortgages until a sufficientnumber have been accumulated for securitization, thereby acting as an intermediary forborrowers and market investors. The vast majority of CMBS issuance today is composed ofconduit transactions. Total 1999 CMBS issuance was about $65 billion.46

CMBS Credit EnhancementsAccording to CMBS rating agency analysts with whom we spoke, as in the RMBS market,the vast majority of CMBS deals are structured with a senior/subordinate form of creditenhancement. Other ways in which credit enhancement can be provided by the structure ofthe CMBS are through overcollateralization, reserve or cash collateral accounts, cross-collateralization, cross-default, hyperamortization, and loan replacement provisions. Credit

44 Standard & Poor’s LEVELS Loan Evaluation and Estimate of Loss System,

www.standardandpoors.com/ratings/structuredfinance/levels/main.htm.

45 www.standardandpoors.com/ratings/structuredfinance/levels/faqlossestimatecoverage.htm, LEVELSFAQs: Loss Estimate/Loss Coverage.

46 Riddiough, Timothy J., “Forces Changing Real Estate for at Least a Little While: Market Structure andGrowth Prospects of the Conduit-CMBS Market,” Real Estate Finance, Spring 2000, p. 59.


support can be also provided by a third-party credit enhancement such as a letter of credit,surety bond, a pool insurance policy, or a corporate guarantee.47

Today, most credit enhancements are used in conjunction with a senior/subordinate dealstructure, not as an alternative. A vice president at Moody’s said cross-collateralization andcross-default are both commonly used with a senior/subordinate structure in cases whereseveral properties are used to secure one mortgage. Letters of credit and surety bonds,guaranteed by a third party such as a commercial bank, are less commonly used, but could beused to provide additional assurance if investors’ level of comfort with the particulartransaction is low. For example, they may be used if investors are not very comfortable withthe property type, such as a health care facility, if investors feel they don’t know very muchabout the property, or if the borrower doesn’t have much experience in managing the type ofproperty being securitized. Reserve accounts are used in specific circumstances where thistype of credit enhancement addresses a particular investor concern. For example, in a retailproperty, if many of the leases will roll over within a 10-year period, the reserve accountwould provide a cushion against a market downturn at the time the leases roll over. Poolinsurance and corporate guarantees are very rarely used.

Subordination SizingThe level of credit enhancement, or the size of the subordination, required for a particularinvestment rating is determined by a rating agency. The rating agencies generally define basecredit enhancement levels to reflect the probability of default and the degree of lossesexpected given a default for a standard set of loan assumptions. Analysts at ratings agencieswe spoke with agreed that the debt service coverage ratio (DSCR) and LTV are the bestindicators of default probability and loss severity, respectively.

In addition to DSCR and LTV, rating agencies examine other loan-level characteristicsincluding loan seasoning, loan type, and the property types collateralizing the loans. Forexample, hotels are viewed as risky investments because of their short-term leasing horizons,their profit sensitivity to management quality and the sector’s susceptibility to overbuilding.Conversely, increases in retail and multifamily pool composition result in lower subordinationlevels.48

47 Forte, Joseph Philip, Capital Markets Mortgage, and Wratten, Thomas F., Introduction to Commercial

Real Estate Secondary and Securitization Market, 1996.

48 Riddiough, Timothy J., and Catherine Polleys, Commercial Mortgage-Backed Securities: An ExplorationInto Innovation, Product Design and Learning in Financial Markets, 1999.


Other important factors include the quality of origination,49 the size of the asset pool, andother pool-level factors such as borrower concentration, geographic diversity, economic risks,and pool servicer experience and creditworthiness.50 Exhibit 7 provides the base lossassumptions reported by Fitch IBCA for commercial mortgages as a function of the property’sDSCR estimated by Fitch IBCA. These base loss assumptions are adjusted up or down toreflect variations from standard assumptions about the property, loan pool characteristics, andthe financial structure of the pool. The expected loss is the product of the probability ofdefault and the degree of loss severity given a default. The expected loss indicates the degreeof credit enhancement required to mitigate expected losses.

Exhibit 7Fitch IBCA Base Loss Assumptions for an A Rating

Fitch DSCR Default Probability (%) Loss Severity (%) Expected Loss (%)

1.50-1.74 25 40 10.0

1.35-1.49 28 40 11.2

1.25-1.34 32 40 12.8

1.15-1.24 35 40 14.0

Source: Fitch IBCA, 2000 and author’s calculations.51

As shown in Exhibit 7, Fitch’s base loss assumptions for an ‘A’ rating range from 10.0 percentfor loans with DSCR of 1.50 to 1.74 to 14.0 percent for loans with a DSCR of 1.15 to 1.24.In comparison, Exhibit 8 below indicates the degree of credit enhancement, or percentage ofpool UPB issued as subordinate debt, called for by Duff & Phelps for rating categories fromBBB to AAA. The Duff & Phelps base-case credit enhancement estimates are based onproperties meeting both LTV and DSCR standards. As with Fitch, the base-case scenarioassumes certain property and loan pool characteristics with deviations from these standardsresulting in a modification in the credit enhancement levels.52

49 High-quality origination may involve experienced staff, training, well-defined policies and procedures,

formal approval processes, quality control, strong loan documents, and other practices. (Fitch IBCA,“Performing Loan Securitization Update,” March 2000, p. 6.)

50 Forte, Joseph Philip, Capital Markets Mortgage, 1996, p. 22.

51 Fitch IBCA, Performing Loan Securitization Update, March 2000. Base loss assumptions correspond tothose experienced during a period of real estate stress in the early 1990s.

52 Among Duff & Phelps base-case assumptions are: the loans are fixed-rate with a 25-year amortization anda seven year term and five years of seasoning; the property is class B quality in good urban or suburbanlocations; the average loan size is $5 million; the loan pool is geographically diversified (with no stateexposure in excess of 5 percent), has at least 100 loans, and no loan accounts for more than 1 percent oftotal UPB; and the servicer and special servicer capabilities are deemed above average.


Exhibit 8Duff & Phelps Base-Case Credit Enhancement Guidelines for Multifamily Properties

Loan Characteristics Credit Enhancement Level

LTV DSCR AAA AA A BBB

60 1.50 13.9 10.3 7.6 5.3

65 1.45 18.1 13.4 9.9 6.9

70 1.35 23.9 17.7 13.1 9.1

75 1.25 31.4 23.3 17.2 12.0

80 1.15 40.1 29.7 22.0 15.3

Source: Duff & Phelps, August 1998.

In comparing the ‘A’ credit enhancement levels, Duff & Phelps criteria appear somewhatmore conservative than Fitch IBCA, except at the highest DSCR level. For DSCR of 1.45,Fitch IBCA is more conservative, with a base-case calling for 11.2 percent credit enhancementwhile Duff & Phelps calls for 9.9 percent. For lower levels of DSCR, Duff & Phelps’standards are somewhat more conservative. For a DSCR of 1.15, Duff & Phelps call for a22.0 percent credit enhancement while Fitch IBCA’s base case only calls for 14.0 percent. Ofcourse, a direct comparison between the agencies is difficult given the many base-caseassumptions that must be taken into account. The most stringent level of credit enhancementfor Duff & Phelps is 40.1 percent for loans with an LTV of 80 and a DSCR of 1.15 that areseeking a triple-A rating.

Recent Trends in Subordination LevelsThe subordination level required for an AAA-rated security has dropped from the mid-30percent range on average in the mid- to high 20 percent range today. This is likely the resultof several factors. First, the healthy economic environment generally and the robustcommercial real estate market in particular have likely contributed to reducing the perceivedfuture risk of these investments. Second, a study by Riddiough found evidence to suggest thatrating agencies were initially conservative in setting subordination levels because ofunfamiliarity with CMBS.53

One CMBS ratings agency analyst we spoke with said that the average credit quality of poolshas actually increased in recent years. This has happened for two major reasons. First,institutions that buy the junior securities, also called B pieces, have gained clout and becomemore aggressive about the composition of pools they will invest in. Until its bankruptcy in

53 Riddiough, Timothy J., and Catherine Polleys, Commercial Mortgage-Backed Securities: An Exploration

Into Innovation, Product Design and Learning in Financial Markets, 1999.


1998, Crimii Mae had purchased about half the B pieces in the market. The remaining B-piece buyers, probably anxious to avoid similar fates, felt that Crimii Mae had bid down pricestoo low, making spreads too tight. Consequently, the remaining buyers now spend as much as$1 million in reviewing the bond, including visiting properties, in making their investmentdecision. Before agreeing to make an investment, some B-piece buyers demand that 10 to 20percent of properties they view as too risky be removed from pools, which improves the creditquality of the pool.

In addition, the ratings agency analyst said issuers are providing better, more accurate, andmore complete information on the properties in the pool. In previous years, mistakes ininformation presented or missing information prompted greater scrutiny from ratings agencies,and pools were penalized with larger required subordination levels for a given rating. Becauseissuers now know what kinds of information analysts are looking for and what theconsequences are for providing inadequate information, these mistakes are now less likely tooccur.

Affordable Housing CMBSThe CMBS market is not particularly well suited for securitizing affordable housing loans.According to one lender we interviewed, affordable housing CMBS are issued almostexclusively as a single loan rather than as part of a pool of loans. The characteristics ofaffordable housing loans, such as high (90 percent) LTVs and low DSCRs (115) make themunlikely to be included in a CMBS composed of a pool of loans because the levels ofsubordination required to credit enhance the CMBS would be too high to make thetransaction efficient.

However, single-loan MBS are more likely to be credit enhanced and issued by Fannie Maethrough its DUS product, than by other CMBS issuers. The depository institutions that aresubject to the Community Reinvestment Act are unlikely to issue their own CMBS, becausethey don’t have the necessary capital and liquidity to execute such a transaction. In addition,since the interest rate upheaval of mid-1998, which resulted in the bankruptcy of CMBSissuers such as Nomura, financial institutions are wary of the interest rate risk involved inwarehousing loans until a sufficient quantity can be aggregated to pool and securitize into aCMBS.


4. Conclusions

This chapter summarizes our findings regarding the use of credit enhancements by the GSEsand how the practices of the GSEs compare to other secondary market participants. The firstsection describes the motivations of different actors in the market in employing creditenhancements. The specific credit enhancements investors use vary across participants in thesecondary market, reflecting differences in the regulatory environment faced by each entity,differing abilities to raise capital, and an orientation toward serving different segments of themarket. The second and third sections then summarize our findings regarding the use ofcredit enhancements in single-family and multifamily transactions. The chapter concludes witha discussion of factors affecting likely future trends in the use of credit enhancements by theGSEs and in the secondary market generally.

Motivations for the Use of Credit Enhancement

A variety of economic and regulatory incentives exist for the use of credit enhancements. Thevarious parties in a loan sale transaction are affected by these incentives in different ways, andtherefore use credit enhancements in ways that are suitable for their set of circumstances.Some of these incentives are unique to the GSEs, and explain many of the differences in theuse of credit enhancements between the GSEs and non-agency mortgage-backed securities(MBS) issuers. Among the many factors influencing the use of credit enhancements are:

• The GSEs’ charters;

• Risk management, reflecting the differing willingness and ability of various partiesto bear risk;

• The GSEs’ housing goals;

• Risk-based capital requirements established by both government agencies andrating agencies; and

• Information asymmetries between the buyers and sellers of mortgages.

These motivations help to explain some of the differences in the use of credit enhancements byagency and non-agency issuers that are discussed in the next sections.

Some of the GSEs’ use of credit enhancements in the secondary market for single familymortgages is a result of their charter requirements. The GSEs’ charters require creditenhancement in any single-family mortgage with a loan-to-value ratio (LTV) at the time themortgage is purchased by the GSE of more than 80 percent. Three credit enhancement


options are available to the GSEs to meet this requirement: participation, repurchaseagreements, and mortgage insurance, with the latter by far the most common method formeeting this requirement.

That the GSEs’ use of credit enhancements is also driven by risk management goals isevidenced by the fact that the level of mortgage insurance they require of high-LTVborrowers is higher than that required by their charters. In addition, credit enhancements arecommonly used that do not necessarily fulfill charter requirements, such as both GSEs’ use ofpool insurance for single family mortgages, particularly for loans with LTVs below 80percent. In addition, Fannie Mae makes extensive use of risk-sharing in its multifamily DUSproduct, despite the fact that there are no explicit charter requirements for creditenhancements on multifamily purchases. It appears, therefore, that credit enhancementswould be used whether required by the GSEs’ charters or not; it is less clear what the levels ofcredit enhancement would be or what form of credit enhancements would be used.

Other regulatory provisions that could affect the GSEs’ use of credit enhancements are thehousing goals and the rules for awarding credit toward these goals established by HUD toensure that the GSEs activities provide benefits for low- and moderate-income households.Currently, the GSEs receive full credit toward their housing goals for purchases of loans withcredit enhancement, except those purchased through the FHA risk-sharing reinsuranceprogram, for which they receive half credit. It is interesting to note that, as described below,Freddie Mac’s approach to multifamily purchases is much different than Fannie Mae’s.Freddie Mac makes very little use of credit enhancements in its multifamily purchases, andthus would likely be unaffected by a change in rules for awarding housing goals credit.

Risk-based capital requirements are also an important motivation for the use of creditenhancements by the GSEs. Although final rules have not yet been established, the Office ofFederal Housing Enterprise Oversight (OFHEO) has issued proposed risk-based capital rulesfor the GSEs, and some developments in the types of credit enhancements available appear tobe a response to these rules. For example, tiered primary insurance policies, a relatively newform of credit enhancement, have been structured to better meet the GSEs’ anticipated capitalrequirements from OFHEO.

The types of credit enhancement that are commonly used are also affected by risk-basedcapital requirements of primary mortgage market participants. In the wake of the FinancialInstitutions Reform, Recovery and Enforcement Act of 1989 (FIRREA), new risk-basedcapital requirements were instituted for depository institutions. The risk-based capital rulesthat were adopted may limit the incentives for depository institutions to provide recourse onloans sold on the secondary market. For example, selling assets with recourse generallyprovides no capital relief – a depository institution is still required to hold risk-based capitalagainst these assets unless the total possible losses under the recourse agreement are less than


the risk-based capital requirement (generally 4 percent for single-family mortgages and 8percent for multifamily mortgages). Of note, however, the low-level recourse rule, whichallows sellers with a recourse obligation less than the risk-based capital requirement to reducethe amount of capital they must hold against these assets, is part of the motivation for thedevelopment of the FHLBs’ MPP and MPF programs.

Ratings agencies also effectively establish capital requirements for MBS issuers by issuingratings for these organizations based on their capitalization levels. Through these ratings,various forms of credit enhancements are either encouraged or discouraged in varioussegments of the market. For example, because of their charters and their agency status,Freddie Mac and Fannie Mae securities are considered to be AAA rated, and provide high-quality corporate guarantees of the timely payment of the principal and interest on mortgage-backed securities. Private-label issuers’ securities would not be considered by the ratingagencies to be AAA rated without some additional credit enhancement, and therefore theytypically do not provide a corporate guarantee for their issues. Instead, to achieve AA- andAAA-rated securities, private-label issuers must provide additional credit enhancement, whichis commonly in the form of a senior/subordinated structure.

Credit enhancements such as mortgage insurance and pool insurance shift the burden of creditrisk from an investor to an insurer. Through agreements to cover losses in specifiedcircumstances, some or all of the instruments’ credit risk is transferred from the owners of themortgage-backed instruments to the credit enhancer, which is more willing or able to bear therisk than the investor. The credit risk may be more efficiently borne by the insurer eitherbecause of differences in their regulatory incentives, financial structure, or business practices.

Last, credit enhancements on mortgages purchased in the secondary market are used toaddress the information asymmetry that exists to the extent that loan originators may be in abetter position to evaluate loan quality than secondary market investors. By placing someresponsibility for the performance of the mortgage on the loan originator, primary lenders areprovided with financial incentives that align the interests of the loan originator and theinvestor in making prudent underwriting decisions. As discussed in the literature review inAppendix A, the use of credit enhancements has the potential to improve the efficiency ofmarket outcomes in the context of information asymmetries.

Credit Enhancements in the Single Family Mortgage Market

In the single family mortgage market, mortgage insurance is used by both agency and non-agency residential mortgage-backed securities (RMBS) issuers for loans with LTVs over 80percent. In addition to their goal of managing credit risk, one of the primary drivers of FannieMae and Freddie Mac’s use of mortgage insurance is their charter requirements. The GSEs’charters require them to use either mortgage insurance, participation, or repurchase


agreements for loans with LTVs over 80 percent. Non-agency RMBS issues backed byjumbo loans also make extensive use of borrower-paid mortgage insurance for loans withLTVs over 80 percent.

Once the GSEs provide their guarantee to a pool of mortgages, no additional creditenhancement is required of the GSEs to create AAA rated securities backed by single-familyloans. The majority of the credit risk in single family agency RMBS is borne by the primarymortgage insurer through insurance obtained by the borrower. The remainder of the creditrisk is retained by the GSEs. The seller only very rarely retains any credit risk.

Lacking the implicit backing of the U.S. government, non-agency RMBS issuers must rely onadditional credit enhancements in order to create AA and AAA rated securities. In the jumbomarket, the additional credit enhancement provided is virtually always subordination in astructured security. In the subprime market, where borrower-paid mortgage insurance is lesscommon (because loans are less likely to have LTVs above 80 percent), the most importanttypes of credit enhancements are bond insurance and corporate guarantees.Overcollateralization and excess spreads tend to be used in combination with bond insurance.The use of subordination in a structured security is becoming increasingly common in thesubprime market.

Credit enhancements are also critical to the functioning of the FHLBs’ MPF program andMPP. In these programs, unlike the vast majority of loan sales to Fannie Mae and FreddieMac, sellers retain some credit risk. Sellers are compensated for keeping some of the creditrisk with a credit enhancement fee. In addition to the credit enhancement provided by sellers,mortgage insurance is commonly used for loans with LTVs over 80 percent. Some of theMPF products also make use of credit enhancements such as spread accounts andsupplemental mortgage insurance. Deep losses are covered by the FHLB.

In neither the GSEs’ single family purchases, the non-agency RMBS issues, nor the FHLBs’programs is the seller generally required to take more than 50 percent of the risk. In non-agency MBS issues, losses are covered by mortgage insurance, the subordinated securities,and the other credit enhancements included in the deal.54 Similarly, for lenders who sell to theGSEs, losses are typically covered by mortgage insurance or by the GSEs. Rarely, lenderswill enter into a repurchase agreement with the GSEs; in this case, lenders are responsible forall losses. Depending on the level of loss and whether or not the loan is covered by mortgage

54 As discussed earlier, the seller may still provide the credit enhancement in a subordinated security if they

hold the subordinate, or B, piece of the security. The market for subordinate pieces is not very liquid, sothe seller may not be able to sell this portion of the security. In the case that the seller holds thesubordinate piece of the security themselves, the seller is providing the credit enhancement by owning asubordinate security that will absorb all losses until the subordinate security is reduced to zero.


insurance, the seller may take 50 percent of the loss or more in some of the FHLBs’programs.

Credit Enhancements in the Multifamily Mortgage Market

No credit enhancement similar to mortgage insurance exists in the multifamily mortgagemarket.55 Instead, virtually all non-agency CMBS issues are credit enhanced usingsubordination in a structured transaction. The GSEs take very different approaches tomultifamily credit enhancements. Freddie Mac’s Program Plus does not require sellers toprovide any credit enhancement. Instead, Freddie Mac addresses the problems of adverseselection and low-quality underwriting by re-underwriting every loan it purchases. In itsnegotiated transactions business, Freddie Mac makes greater use of credit enhancements.Credit enhancements used commonly include recourse, cross-collateralization, cross-default,and third party credit enhancements.

In contrast, Fannie Mae uses credit enhancements extensively in its DUS product, throughwhich it acquires the majority of its multifamily mortgages. Loans originated by DUS lenderseither through Fannie Mae’s standard products or through the Small Multifamily 5-50 productinvolve loss sharing. In the most common scenario, the lender provides first-loss coverage upto 5 percent of the original balance and then shares losses with Fannie Mae up to 20 percentof the UPB. Beyond this, lender losses are capped at a maximum of 20 percent of theoriginal principal balance. Any losses beyond 20 percent of the original principal balance areborne by Fannie Mae. Credit enhancements are not required of sellers in Fannie Mae’sAggregation Facility; however, it sees very little use. In its other negotiated transactions,Fannie Mae generally requires the seller to provide first-loss coverage for MBS swaps. Thiscoverage can be collateralized using a letter of credit, a cash collateral account, poolinsurance, or a corporate guarantee. For REMIC swaps, sellers are not required to providerecourse. The credit enhancement is structured into the transaction through the use ofsubordinated securities that take all losses on the entire pool of mortgages.

In the non-agency market, subordination in a structured transaction is virtually always used asthe primary credit enhancement. Cross-collateralization and cross-default are also used withsubordination, particularly when the pool includes a borrower with a loan on multipleproperties. Although the seller bears no responsibility for loss, lenders are motivated to usequality underwriting by the rating agencies’ assessment of the size of subordination necessaryfor a particular loan for a given rating. The lender’s profit from selling both the senior andsubordinate pieces is maximized when the size of subordination is minimized. Other credit

55 FHA is the only source of multifamily mortgage insurance, and FHA rules place limits on the value of

properties that may be insured to limit its activity to the low- and moderate-income segment of the market.


enhancements used include overcollateralization and third party credit enhancements such as aletter of credit, pool insurance, or a corporate guarantee.

The only situations where the seller may be required to cover 50 percent or more of losses arein Fannie Mae’s DUS and both GSEs’ negotiated transactions. Although the seller is notresponsible for losses beyond 20 percent of the UPB of a loan in the most common risk-sharing regime in DUS, the portion of the losses actually covered by the seller may be 50percent or greater depending on the level of loss sustained. In DUS, assuming moderatelosses, lenders bear more than 50 percent of losses under both Level II and Level III loss-sharing provisions. However, Fannie Mae bears more than 50 percent of losses in the event ofa total loss under every loss-sharing regime.

Sellers may also be required to cover 50 percent or more of losses in both GSEs’ negotiatedtransactions. In a negotiated transaction with either GSE, the degree of risk borne by theseller depends on the level of recourse negotiated. Fannie Mae reported that in some cases,lenders accept full recourse. In this case, the lender benefits from the liquidity provided by theGSE but not by relief from risk-based capital requirements or credit risk. In transactionswhere lenders take partial recourse, the share of losses they bear depends on the size of therecourse provided and the level of loss on the loan. In a Fannie Mae REMIC swap, the sellermay also bear losses if they are unable or unwilling to sell the subordinated security. In thiscase, they hold the security that provides credit enhancement to the senior securities created inthe transaction.

In its report evaluating HUD’s effectiveness as a regulator of the GSEs, the GeneralAccounting Office (GAO) questioned whether the GSEs should receive full credit formultifamily mortgage purchases where the mortgage originator provides credit enhancementsto cover most default-related losses. Our review of the use of credit enhancements by theGSEs in multifamily transactions has found that while there are situations under whichoriginating lenders could potentially bear a large share of losses, the GSEs are generallyresponsible for the majority of losses when the magnitude of the loss is high. As has beendiscussed, the GSEs’ use of recourse is designed to address concerns about risk managementand informational disadvantages relative to originating lenders. These practices appear to bein keeping with the practices of other participants in the secondary mortgage market.

Likely Future Trends in the Use of Credit Enhancements

Credit enhancements are important to the efficient functioning of both the single-family andmultifamily mortgage markets. They serve to allocate risk to the market participants mostreadily suited to bear that risk. In addition to spreading credit risk among market participants,seller-provided credit enhancements are also used to address information asymmetriesbetween secondary market investors and loan originators. Other important factors


determining the use of credit enhancements are laws and regulations governing the actions ofprimary and secondary market participants. Given the importance of credit enhancements tothe efficient functioning of the secondary market, some form of credit enhancements would beadopted even without the regulatory and statutory requirements that motivate their use. It isless clear whether the forms of credit enhancements used or the levels required would changein the absence of these requirements. In general, however, the use of credit enhancements israpidly evolving, and recent changes imply that both agency and non-agency MBS issuers arestill “learning” about the most efficient use of credit enhancements.

In the single family secondary market, the GSEs use credit enhancements beyond thoserequired by their charters, suggesting that credit enhancements fill an important riskmanagement role for the GSEs. It is clear, however, that the GSEs rely on creditenhancements to a lesser extent than non-agency issuers. This is because the GSEs can issueAAA-rated securities that are backed primarily by their corporate guarantee on the strength oftheir charters and agency status. Although they also issue MBS that use a senior/subordinatedstructure, this represents a minority of the securities they issue. In contrast, non-agency issuesalmost always involve a third-party credit enhancement (one other than a corporateguarantee), usually a senior/subordinated structure.

Both the GSEs’ and non-agency issuers’ use of credit enhancements is constantly evolving.This suggests that the levels and types of credit enhancements currently common in the marketare not necessarily the most efficient, but rather the market is constantly developing, newmore efficient approaches. For example, in the single-family market, the GSEs have onlyrecently begun reducing the levels of mortgage insurance required for some types of loans,made possible at least in part by advances in technology designed to better judge the risk ofindividual mortgages. In addition, the GSEs are relying increasingly on single-family creditenhancements that were not widely used a decade ago, such as tiered primary mortgageinsurance and the senior/subordinated structure.

Non-agency issuers’ use of credit enhancements has changed as well. For example, over thecourse of the 1990s, the use of credit enhancements such as pool insurance and corporateguarantees for CMBS has declined as investors have come to accept a senior/subordinatedstructure as sufficient credit enhancement for these deals. In addition, the subordination levelrequired for a AAA-rated commercial mortgage-backed security has dropped from the mid-30percent range on average in the mid- to high 20 percent range today. At least part of thischange can be attributed to the greater familiarity with CMBS by investors and ratingagencies. The market for the subordinated bond, or B pieces, in a CMBS has also undergonerecent changes: buyers of CMBS B pieces learned a painful lesson in the late ‘90s when atleast one major buyer was bankrupted by unexpected market fluctuations. Consequently,while rating analysts have become less conservative in sizing subordination levels, B-piecebuyers have become more conservative.


It is also worth noting that the types and degree of credit enhancements used may also changedrastically in the wake of a downturn in the real estate markets leading to higher losses forinvestors. The 1990s were a period of almost unparalleled prosperity. As a result, much ofthe evolution in the types and degree of credit enhancements used has not yet been tested by asignificant market downturn. Freddie Mac’s experience in the multifamily market isinstructive in this regard. After experiencing significant losses on multifamily loans originatedin the 1980s, Freddie Mac withdrew from this market for several years. Upon its return to themultifamily market in the early 1990s, Freddie Mac adopted a conservative approach tomultifamily loan purchases that requires reunderwriting each loan it purchases. In the event ofanother market downturn, it is possible that other market participants will also change theirapproach to evaluating and structuring transactions.

In short, the use of credit enhancements will continue to evolve in response to increases ininformation about the performance of mortgages and different financial products over time,innovations in financial structures, changes in laws and regulations, and fluctuations in theeconomy.


Appendix AReview of Literature Related to InformationAsymmetries and Credit Enhancements inTransactions Between GSEs and MortgageLenders56

Abstract

This report reviews the literature related to asymmetric information as it relates to the use ofcredit enhancements by Fannie Mae and Freddie Mac, the two principal governmentsponsored enterprises (GSEs) in the mortgage market. There does not appear to be anypublished research that addresses the question directly. There is, however, an extensiveliterature that addresses the implications of asymmetric information in the credit and securitiesmarkets, and in particular the implications of asymmetric information in the sale of loans.Many of these studies discuss the resource allocation effects of alternative arrangements, andcompare the resulting equilibrium with that which would exist with perfect symmetricinformation. The majority of the published work on this topic takes the view, or implies that,the use of credit enhancements has the potential to improve the efficiency of market outcomesin the context of information asymmetries.

Overview

The main difficulties with mortgage transactions between lenders and GSEs (particularly forexisting loans) result from asymmetric information and adverse selection that results frominformation asymmetry. A number of studies (Stiglitz and Weiss, Jaffee and Russell) haveconcluded that in a credit market characterized by asymmetric information, some potentialborrowers will be unable to obtain credit. The adverse selection issue is less severe in thecontext of continued transactions over time (James, Spence, Cutts et al.) but if the potentialgain from one transaction is large relative to the net present value of expected futuretransactions, there is still an incentive for sellers to foist off low quality loans to a GSE andthen disavow any knowledge or responsibility if the loan turns sour.57

56 This section was prepared by Brian Maris, a professor of finance at Northern Arizona University.

57 As pointed out by Timothy Riddiough, for single family mortgages, in many ways the GSEs have aninformation advantage over loan originators, due to their experience, access to data, and investment inresearch. (Personal correspondence)


The sharing of default risk between the lender and the GSE does not eliminate the adverseselection problem. There is still an incentive for lenders to retain loans with the lowest defaultrisk in their own portfolios and to offer loans with higher default risk to the GSEs. Iftransactions are arranged so that the lender retains all of the default risk on sold mortgages, bysecuritizing existing mortgages and offering mortgage-backed securities that are free ofdefault risk to GSEs, some models of bank behavior (Benveniste and Berger, Greenbaum andThakor) indicate that lenders will actually retain the riskier loans in their portfolios andsecuritize the loans with lower risk. (It must be pointed out that those studies are based onthe lending bank maximizing the value of deposit insurance to bank equity holders, and mightnot apply to non-bank lenders. However, Riddiough (1997) arrives at the same conclusionwithout relying on a banking model. In this case, if the original lender retains all default risk,the GSE receives a guaranteed return, and there is no adverse selection.

Several studies (Greenbaum and Thakor, Benveniste and Berger, Riddiough) conclude thatrather than sharing risk, a better approach (in terms of maximizing the value received by thelender) is for the original lender to retain the default risk and securitize the loans. However,this conclusion does not take into consideration other public policy objectives with regard tothe secondary market, such as mortgage market liquidity or housing affordability.

The information asymmetry literature reviewed here can be grouped into the followingcategories: (i) credit rationing; (ii) financial intermediation; (iii) credit enhancements; and (iv)secondary mortgage markets. Studies pertaining to each of these sub-topics is reviewed arereviewed in the following discussion.

I. Literature Related to Information Asymmetries and CreditRationing

Akerlof (1970) is a classic article related to the implications of asymmetric information inproduct markets. When sellers have better information about the quality of what is being soldthan buyers have, it creates adverse selection. Buyers will assume what is being offered forsale is of low quality, so sellers will be unable to receive full value for high quality products.This results in a Gresham’s Law effect, in which low quality products drive higher qualityproducts out of the market.

Stiglitz and Weiss (1981) present a model of credit markets in which some potentialborrowers are unable to receive loans even though they are willing to pay the market interestrate, or even a higher rate. Banks are unwilling to increase the interest rate because it wouldincrease the riskiness of the loan portfolio and reduce returns net of losses. Their model relieson information asymmetry (potential borrowers have information related to credit worthinessthat is unavailable to lenders). As a result, lenders lack the ability to accurately estimate


default risk. If lenders increase the interest rate, only the borrowers with the greatest defaultrisk are willing to pay the higher rate.

Jaffee and Russell (1976) present a model of the credit market in which borrowers have moreinformation about the likelihood of default than lenders have. They conclude that if the loanmarket is competitive, the existence of information asymmetry will cause one of two possibleoutcomes. If only one type of loan contract is offered to the market, the market might reach astable equilibrium in which credit is severely rationed. That is, the equilibrium is one in whichthe volume of credit demanded is much greater than the volume of credit that is supplied bylenders (consistent with Stiglitz and Weiss, 1981). Alternatively, the loan market mightoscillate unstably if multiple loan contracts are offered. This result occurs because the defaultrisk of borrowers will be revealed in a dynamic fashion through their loan preferences.

Vandell (1984) contradicts Jaffee and Russell’s (J-R) results and shows that they are the resultof specific assumptions that limit the generality of their model. Vandell refutes three pointsthat are critical to J-R’s results. J-R assume that certain borrowers have no expectation ofdefault, and that borrowers who do have a positive expectation of default behave like thosewho have a zero expectation of default in their demand for credit. Vandell argues that a morerealistic assumption is that all borrowers have a positive expectation of default, and that thoseexpectations are revealed in their preferences for credit. Furthermore, Vandell asserts thatcredit rationing in the single-contract equilibrium case is the result of an inappropriate measureof the “price” of credit in Jaffee and Russell’s model and does not necessarily occur if thesupply of credit is properly specified. In J-R’s model, the “price” of credit is defined to be theloan contract rate. Vandell argues that both borrowers and lenders, a better definition of theprice is the yield net of default costs. Vandell demonstrates that if the cost of credit is sospecified, the multi-contract unstable equilibrium that J-R derived cannot occur.

II. Literature Related to Information Asymmetries and FinancialIntermediation

Diamond (1984) provides a theoretical justification for the existence of financialintermediaries based on minimizing monitoring costs. In Diamond’s model, borrowers havebetter information than lenders do about the actual, ex post returns from an investmentproject. It is costly for lenders to obtain information about realized project returns. In theabsence of financial intermediaries, the only source of credit would be direct loans fromsavers. However, multiple lenders results in increased monitoring costs. If many lenders areneeded to fund one borrower and each lender must independently monitor the borrower’sperformance, the result is duplication of monitoring costs and greater total monitoring cost.Diamond argues that financial intermediaries can fulfill this monitoring role and eliminate theduplication of monitoring costs.


In addition, Diamond argues that diversification is a key advantage of intermediation, even ifall participants are risk neutral. His model also imposes penalties (bankruptcy costs) ifpayment on the loan is insufficient (i.e., default occurs). The optimal financing arrangementminimizes the sum of monitoring costs plus the expected value of bankruptcy costs. The typeof financing arrangement that minimizes those costs is debt financing provided through asingle lender which serves as an intermediary by bearing the default risk and assuming theresponsibility for monitoring.58 Ultimate lenders then need only monitor the intermediary’scondition, rather than monitoring each borrower’s performance.

Diamond and Rajan (1999) approach the issue of bank capital “by modeling the essentialfunctions that banks perform and then ask what role capital plays” (p. 1). In the model,entrepreneurs have projects that require financing. The entrepreneur can generate greatercash flows from the project than outsiders can. Because labor contracts are generallyunenforceable, the entrepreneur cannot commit his human capital to the project, except in thespot market. Outside financiers can force repayment only by threatening liquidation of theproject. However, because outsiders are at a disadvantage relative to the entrepreneur in theoperation of the project, it has greater value to the entrepreneur than to others. As a result,lenders can extract only a portion of the potential cash flows that a project can generate.Because of that, projects have inherent illiquidity: they cannot be financed to the full extent ofcash flows they are expected to generate.

The lender becomes a “relationship lender,” developing the ability to redeploy project assetsand increasing the proceeds from the sale of those assets if they are liquidated in lieu ofrepayment. This results in a situation in which the loan has greater value to the original lenderthan it has to others, and effectively prevents a secondary market for the loan. Like theproject, the loan is also illiquid, and for the same reason: the original (“relationship”) lendercannot reliably pledge his superior ability to recover payments.

Both types of assets (projects and loans) are illiquid because specialized human capital cannotbe committed. A device that ties human capital to an asset creates liquidity. Diamond andRajan argue that a bank is such a device. If the initial financier is structured as a bank, thebanker can commit to pass all cash flows collected from borrowers to depositors. A bankwhich has “the right quantity of deposits outstanding” cannot collect a rent for its abilitiesbecause of its fragile capital structure, making it subject to runs by depositors. Potentialborrowers know that any attempt by the bank to withhold a rent for its abilities will result in arun by depositors, which undermines the bargaining position of the bank relative to theborrower.

58 Thus, external equity financing and direct, disintermediated debt financing are both suboptimal.


Increased bank capital improves the bank’s ability to withstand a random shock to assetvalues, improving the bank’s safety, as expected. Excessive reliance on deposits increases thethreat of a run, and increased bank capital reduces the threat of a run. However, a morehighly capitalized bank can extract greater rent from borrowers, because the threat of a run isless. As a result, (at least some) borrowers might prefer to borrow from less highlycapitalized banks. However, other borrowers might prefer highly capitalized banks becausesuch a bank might lend more initially. Thus the model predicts a type of clientele effect inwhich there is a matching between entrepreneurs and banks, which the authors indicate isconsistent with the empirical results of Hubbard et al. (1999). Diamond and Rajan’s modeldoes not speak to the issue of any possible relationship between bank capitalization and thecost of credit to borrowers, because it assumes risk neutral participants and a zero discountrate.

Hubbard, Kuttner and Palia (1999) focus on the relationship between the financial condition ofa lending bank and the terms of loans that it makes. In the absence of informational frictions,if the loan market is competitive, the interest rate charged to a specific lender should be basedon the banks’ cost of funds and the risk characteristics of the borrower. If a particular bankhas a higher cost of funds than other banks and attempts to pass on that higher cost to itsborrowers, the borrowers would be expected to switch to other lenders. However, theexistence of informational frictions interfere with the ability of some borrowers to switch,creating what the authors refer to as “high switching costs”. Such borrowers might be “good”borrowers in the sense that the risk of default is low, but they have characteristics that make itdifficult for them to change banks. This creates a situation in which borrowers least able toswitch to alternative sources of credit, that are tied to weaker banks, will pay higher interestrates, and/or be subject to credit rationing. That is, in fact, what the results of this studyindicate.

The authors use three proxies to identify business borrowers with high switching costs: nobond rating; small firm size; and borrower is prime-dependent, meaning its loans are all pricedusing prime rate as a base. They conclude that business loans by banks made to unratedborrowers, to small borrowers, and to prime-dependent borrowers are associated with higherinterest rates, even after controlling for loan terms and proxies for borrower risk. (Theauthors believe this result is due to the fact that such borrowers tend to be tied to “weaker”banks. A weak bank is defined as one whose capital as a percentage of total assets is low.)This creates a situation in which “good” borrowers, with a low risk of default, but havingcharacteristics that inhibit their ability to switch to another lender, might be paying higherinterest rates than other borrowers of comparable credit risk. It is possible that a more highlydeveloped secondary market would benefit such borrowers (although this is not a pointaddressed by the authors).


III. Literature Related to Efficiency Properties of CreditEnhancements in the Context of Information Asymmetries

Spence (1976) discusses the economics of informational asymmetry in the general context ofproduct markets. He notes that verbal characterizations of quality by sellers might beinformative. Their credibility is enhanced if transactions are repeated “so that the costs ofseller misrepresentation may take the more concrete form of lost future business” (p. 593).Spence initially describes a market with asymmetric information with no uncertainty on theseller’s part. What he refers to as a “contingent contract” imposes a penalty if the actualquality is less than the stated quality and shifts the risk of nonperformance to the seller(assuming the seller cannot avoid the penalty). In the context of the secondary mortgagemarket, credit enhancements can be interpreted as a contingent contract of the sort Spence isreferring to. If the penalty for nonperformance is “appropriate” sellers will always reporttruthfully, and the penalty will never be paid. The resulting equilibrium is “in terms ofresource allocation, indistinguishable from an equilibrium with perfect symmetric information.Thus, with no seller uncertainty, contingent contracts are efficient signaling mechanisms” (p.594).

Spence notes that if there is residual uncertainty on the seller’s part (as is always the case inthe mortgage market), contingent contracts are still effective (but not costless) mechanisms.The cost results if the seller is more risk averse than the buyer because the penalty must bepaid in some situations. He notes that “seller-risk absorption is of no consequence if sellersare risk-neutral. If they are, contingent contracts remain fully efficient. But, if sellers are risk-averse, and buyers are not, or are less so, then there is a cost to transferring risk to the supplyside. Therefore, risk spreading and the transmission of information may be in conflict” (p.595). The implications of Spence’s model for the secondary mortgage market are that signalsthat reduce uncertainty are beneficial, allowing better risk assessment and risk-based pricing.

Townsend (1979) shows that when it is costly for external financiers to monitor the outcomeof a project, debt (rather than equity) allows monitoring costs to be minimized. In his model,the principals can observe the proceeds of their investment opportunities, while externalinvestors can do so only at a cost. Because verification is costly, financing should bestructured so that verification is unnecessary in most situations. If external investing is in theform of equity, investors must pay the costs of monitoring the performance of the project, toinsure that they are receiving their share. Debt minimizes monitoring costs by specifying acontractual interest payment to lenders. The normal outcome is for the borrower to pay thepre-specified amount, and the lenders accept the promised payment without paying monitoringcosts. Only if default occurs is monitoring required by lenders. In that situation, lendersreceive the realized value of the project, which they must ascertain by incurring monitoringcosts.


An unstated implication of Townsend’s model for the secondary mortgage market is thatcredit enhancements, like debt, might be a mechanism for reducing monitoring costs.Allowing recourse to the loan originator could reduce transaction costs between lenders andthe secondary market.

Leland and Pyle (1977) present a model in which borrowers are not entirely truthful and it iscostly or impossible for outside parties to verify the true characteristics of borrowers directly.However, it is possible for borrowers to provide signals regarding their quality. Such signalsare not without cost to the borrower. For example, lenders can infer project quality by thewillingness of persons with inside information to invest in the project. They conclude that thewillingness of an entrepreneur “to invest in his own project can serve as a signal of projectquality” (p. 372). The counterpart for this in the context of a mortgage would be forborrowers to signal quality by increasing the size of the down payment. It should berecognized, however, that some low-risk borrowers might find it difficult or impossible tomake a large down payment.

The traditional view is that financial intermediation occurs because of transaction costs.Leland and Pyle argue that “informational asymmetries may be a primary reason thatintermediaries exist” (p. 383). They define financial intermediaries as “firms which hold oneclass of securities and sell securities of other types” (p. 382).59 Leland and Pyle note “thatfinancial intermediation…can be viewed as a natural response to asymmetric information” (p.372). It might seem that firms with an advantage in obtaining or interpreting informationrelated to project quality could sell the information (providing a service similar to securityraters or credit raters). However, Leland and Pyle note two difficulties facing firms thatattempt to sell such information. One is that information has a public good aspect; purchaserscan share or resell it. Another problem is the difficulty that potential users have in verifying itsvalidity. Both problems are overcome if the information gatherer “becomes an intermediary,buying and holding assets on the basis of its specialized information” (p. 383). The firm withan information advantage benefits by increasing the value of its portfolio.

James (1988) presents a model in to explain why commercial banks in the U.S sell commercialloans to third parties. Some researchers have advanced what James refers to as the “MoralHazard Hypothesis,” which is that deposit insurance together with bank capital requirementscreate incentives for banks to increase financial leverage by issuing contingent liabilities thatare not subject to the same capital requirements. Another explanation that has beenforwarded is the “Regulatory Tax Hypothesis”. According to the Regulatory Tax Hypothesis,banks sell loans to avoid reserve requirements and capital requirements. James argues thatbank regulations alone cannot explain why banks enter such transactions, for two reasons.

59 Based on that definition, GSEs can be considered financial intermediaries.


For one, many of the loans are purchased by other banks. For another, nonbank lenders arealso active in loan sales.

To help explain why banks sell loans, James equates loan sales with recourse by a bank to theissuance of secured debt by the bank. A secured loan is safer than an unsecured loan from thelender’s perspective, thus lowering financing costs. Commercial banks in the U.S. areprohibited from borrowing in the form of secured loans. Banks can, and do sell commercialloans to third parties, however. James argues that the sale of loans (with recourse) by a bankis a substitute for secured borrowing by the bank. He differentiates this from both the MoralHazard Hypothesis and the Regulatory Tax Hypothesis, although he indicates that his modelcomplements rather than contradicts those explanations.

James notes that for loans sold without recourse, the purchaser faces an adverse selectionproblem in terms of the quality of loans offered for sale, and a moral hazard problem in thatthe original lender has no incentive to continue monitoring the borrower. He suggests oneway to reduce those problems is for the original lender to fund a portion of the loan sold, thusretaining a portion of the default risk. This helps explain why lenders would provide creditenhancements for their loan sales. However, James also notes that because “selling banks arerepeatedly in the market, ‘reputational’ capital may assure quality” (p. 398).

Greenbaum and Thakor (1987) present a banking model in which banks have a cost advantagein screening borrowers that allows them to originate loans more efficiently than others. Theyseparate the lending function (at which banks excel) from the method of funding bank loans.Bank loans can be funded either (in the traditional manner) by bank deposits or (in thecontemporary manner) securitized by pooling them and issuing marketable securities withclaims against the pool of loans (in the same manner that mortgages are securitized byGNMA, FNMA and FHLMC). The securitization process involves the bank providing creditenhancements that partially guarantee investors in the securities against default. Greenbaumand Thakor show that in the absence of informational asymmetries, deposit insurance andbank regulations, all parties (banks, depositors, and borrowers) are indifferent as to whetherthe bank retains the loan and funds it with deposits, or sells it to investors via securitization.

In the context of Greenbaum and Thakor’s model, borrowers cannot reveal quality by theircredit choices. Banks and nonbanks can screen borrowers (at a cost) to estimate default risk,but banks have a cost advantage in screening borrowers. The cost of screening is less than thesavings that result from screening for at least some (high quality) borrowers, so high qualityborrowers will insist on screening, and the bank’s assessment of a borrower’s default risk canbe passed on to investors via the bank’s willingness to provide guarantees on securitizedloans. This allows investors to avoid incurring the cost of screening individually (which arehigher than bank’s screening costs). With asymmetric information about default risk and no


deposit insurance or government regulation, banks will securitize their highest quality loans,and the lowest quality loans will be funded by deposits.

In the case of asymmetric information combined with bank regulation, it is possible that allloans will be funded by deposits, if the net effect of all bank regulation is to reduce bank costs(as, for example, if the savings that result from subsidized deposit insurance and underpricedcentral bank services exceeds the additional costs imposed by reserve requirements and otherrestrictions). However, if the net effect of bank regulation is to increase bank costs,Greenbaum and Thakor conclude that loans to the best quality borrowers will still besecuritized by banks.

Carlstrom and Samolyk (1993) discuss the economic rationale for asset-backed lending,including but not limited to mortgage lending. This article uses the term “asset-backedlending” to refer to both loan securitization and individual loan sales. According to them, a“major difference between loan sales and securitization is that loan sales usually provide norecourse for the party buying the loan60…Banks and thrifts are not required to hold capitalagainst loans sold, except for those sold with recourse” (pp. 3-4 of reprint of article obtainedfrom internet). This creates a regulatory incentive for depository financial institutions to sellloans without recourse. Outside investors, however, prefer some form of credit enhancementto offset their informational disadvantage and the associated adverse selection problem.Carlstrom and Samolyk note that securitization (as opposed to loan sales) “on the other handis generally associated with the provision of some form of credit enhancement…” (p. 4 ofreprint).

Benveniste and Berger (1987) present a model in which banks are the initial lenders. Theydefine asset securitization as “the process by which illiquid bank assets are pooled orguaranteed to make them marketable” (p. 403). They conclude that the funding of loans by“securitization with credit enhancements—such as full recourse to the selling bank--isprofitable for the selling bank and can result in a more efficient allocation of the risks” (p.405). They believe that the “risk-sharing benefits of securitization with recourse are the sameas those of multiclass securities,” (p. 404) which are characterized as “securities withsequential claims (that) are issued against the same collateral pool” (p. 403-4). The process ofsecuritization is an alternative to funding bank loans with deposits. Benveniste and Bergerstate that the most common form of securitization with recourse is the Standby Letter ofCredit (SLC), which is a bank guaranteeing repayment of a loan made a third party to a bankcustomer. One prediction of their model is that loans securitized by a bank will be safer than

60 This is not entirely consistent with GSE practice, however. In its multifamily transactions, Fannie Mae

commonly uses risk-sharing and recourse arrangements with respect to loan sellers.


the loans retained in the same bank’s portfolio.61 While they lack the data to test thehypothesis formally, they note that for “28 large banks responding to a 1978 Federal Reservesurvey had an average loss ratio of 0.03 percent on SLCs while incurring average balancesheet loan loss rates of 0.41 percent, more than ten times as high, consistent with the model’sprediction” (p. 420).

Riddiough (1997) presents a model of asymmetric information in which lenders, which havean information advantage over outsiders, are motivated to liquidate a portion of the loanportfolio. Two liquidation channels exist: whole loan sale and securitization. Becauseoutsiders are at an information disadvantage, they will value whole loans sold withoutrecourse at less than their fundamental value. A variety of credit enhancements are possible,including cross-default clauses, in which default on one loan triggers default on other loans tothe same borrower. Securitization allows the lender to reengineer the loan into two classes ofsecurities, one of which is riskless and the other which has risk. If the lender retains the riskyclass of securities, the lender can offer riskless securities to outsiders, which allows the lenderto receive full value for liquidated loans. Information problems indicate that lenders willsecuritize higher quality loans and retain lower quality loans. Securitization allows low qualityloans to be combined into a pool, thus diversifying idiosyncratic risk. Bigger lenders canbenefit more from this, so there may be some advantages associated with size.

Riddiough contends that in the case of securitization, the original lender (junior securityholder) should control any post liquidation/renegotiation decisions if default occurs, which ischaracterized as a security governance issue. The rationale for this is that the lender has betterinformation and is in the first loss position, and therefore has the opportunity and the incentiveto maximize the payout, both of which the senior security holder lack. In the absence ofcapital constraints by lenders, Riddiough’s model results in a “pecking order” of financingalternatives by lenders, with internal financing being most preferred (because it minimizes thecosts associated with information asymmetry and adverse selection), followed bysecuritization, and whole loan sale (without recourse) as the least preferred.

IV. Information Asymmetries and Secondary Markets

Passmore and Sparks (1996) present a model in which the mortgage originator (a bank) canobtain information on a mortgage applicant’s default risk at a cost. The mortgage securitizer, 61 The reason for this is that the securitized loans will appeal most to the most risk averse investors.

Securitization with recourse is expected to result in banks making safer loans. The authors note that anadditional benefit of securitization is increased diversification of the bank’s loan portfolio. WhileBenveniste and Berger make no explicit assumption regarding information asymmetry, bank loans differin default risk, and it seems implicit in the model that the bank is in a better position than outsiders tojudge the default risk of loans.


however is unable to obtain such information. They assume that banking is competitive andthat banks therefore earn zero economic profit from mortgage lending. Mortgage securitizingis done by GSEs, which have lower cost of capital than banks. Because of that, GSEs canearn a profit even though they are purchasing mortgages (without recourse to the initiallender) with greater default risk than banks hold. A key assumption of the model is thatscreening costs vary across applicants, so banks will screen only a portion of mortgageapplicants, beginning with those of lowest screening cost, and retain those screened mortgagesthat are of lowest default risk. Mortgage securitizers will be offered screened mortgages ofhigher default risk, and unscreened mortgages. The interest rate is assumed to be the same forall mortgages. The authors conclude that mortgage securitization will result in a lowerpercentage of mortgages being screened, and a higher equilibrium mortgage rate than wouldexist without securitization. This is because they “assume the banking industry is competitive,so that the mortgage rate is determined by a zero economic-profit condition. Hence, eachbank earns zero profits from its optimal combination of screened and unscreened mortgages,but earns positive profits from the screened mortgages themselves. Consequently, unscreenedmortgages are cross-subsidized; they are offered at a lower mortgage rate than they would inthe absence of profitable screening opportunities. Furthermore, if a bank’s optimal level ofscreening declines—so that it picks fewer cherries—the mortgage rate must rise for the bankto maintain zero profits” (p. 28). Passmore and Sparks conclude that a secondary marketresults in higher mortgage rates because banks will screen fewer loans. Banks earn a positiveprofit on screened loans, but because the banking industry earns zero profit in equilibrium, thepositive profit on screened loans must be offset by loses on unscreened loans. BecausePassmore and Sparks conclude that a secondary market results in fewer loans being screened,the mortgage rate must be higher to provide zero profits.62 Passmore and Sparks note thatdifferent groups are affected differently by government-sponsored securitization. Low-riskborrowers are adversely affected due to the higher mortgage rate. However, some high-riskapplicants will benefit because they will receive mortgage loans that otherwise would not havebeen approved.

Cutts, Van Order and Zorn (1999) provide a stylized model of the development of secondarymortgage markets in which the secondary market has a cost advantage over primary lenders(i.e. can obtain funds at lower cost), and primary lenders have an information advantage(regarding the default cost associated with each loan) over the secondary market. Thrifts,which originate mortgages, know the probability of default and the loss associated withdefault for each loan, but the secondary market knows only the distribution of default acrossmortgages.

62 What Passmore and Sparks do not explain is why banks will make any unscreened loans if they result in

net losses.


The simplest model is based on several assumptions, as follows. There are two costsassociated with each loan. One is the cost of funds, which does not vary with default risk (orapparently with the quantity of loans). The cost of funds for thrifts is higher than the cost offunds for the secondary market. The other cost is default costs. Mortgage loans vary in termsof default risk from the safest to the riskiest; default costs are represented by a function that isconvex with respect to default risk. Default costs are the same for thrifts and for thesecondary market, but of course thrifts have an information advantage. The secondary marketdoes not know the default risk of individual mortgages and pays the same price for each loanregardless of quality. The loans offered to the secondary market are the worst, due to adverseselection. The secondary market controls only the quantity of mortgages it purchases. As thequantity increases, loans of higher quality are being purchased, so the marginal cost associatedwith default is decreasing. The result is a marginal cost curve that is not only downwardsloping, but (according to the authors) parallel to the demand curve, preventing a competitiveequilibrium in which all borrowers pay their marginal costs.

If the secondary market is a monopoly, two outcomes are possible. Either the monopolist willact as a loan shark, serving only the highest risk segment of the market, or it will serve theentire market. They note that “small changes in parameters or exogenous variables can leadto large increases in rates and large changes in market structure” (p. 9).

The authors extend the basic model of a monopoly secondary market by introducing what isreferred to as “seller licensing”. Seller licensing involves a contract between the secondarymarket and thrifts that specifies a minimum quality standard. In this case, the secondarymarket can determine some aspect of loan quality, and prices loans according to their risk.The secondary market cannot monitor individual loans, but does observe the default history ofloans purchased from each lender. The secondary market specifies a minimum qualitystandard and offers lenders incentives that are sufficient for lenders to value the opportunity tosell to the secondary market in the future. Seller licensing could be considered a form ofcredit enhancement, although this terminology is not used by Cutts et al.

The seller licensing model is extended to consider the possibility of a more complex loan costcurve, as well as the possibility of allowing the secondary market to distinguish between broadcategories of loan quality. The authors conclude that improved information technology (in themodel, as well as in the real world) “has led to an increased role of the secondary market intoriskier markets as well as pricing on the basis of risk. In these models, as well as in practice,the risk-based pricing by the secondary market is flat over classes of risk, making it costly tothe borrower who just misses the cutoff to the next lowest risk class. However, theborrowers in each risk class pay lower costs than they would in the absence of the secondarymarket’s presence in that market segment” (p. 19). There are two differences between Cuttset al. and Passmore and Sparks that explain their different conclusions. In this (last) versionof the Cutts et al. model (unlike Passmore and Sparks) the secondary market can determine


the risk-class of each loan, allowing risk-based pricing. Also, unlike Passmore and Sparks,Cutts et al., “have not explicitly considered screening costs. Passmore and Sparks consider amodel with variable screening costs and analyze interactions of screening and selectionproblems like those here” (p. 20).

Szymanoski and DiVenti (1998) develop a theoretical approach for comparing risk sharingagreements between FHA and private mortgage insurance (PMI) companies and FHA fullinsurance to determine if the former is a more efficient mechanism for insuring the segments ofthe mortgage market currently being served by FHA’s full insurance program. The pricingand risk implications of FHA entering reinsurance agreements with private insurers areconsidered; the implications of such agreements for FHA’s ability to fulfill its mission with asmaller staff are analyzed; and impact on taxpayer risk is examined. FHA is found to be betterable to accomplish its mission at an acceptable risk level if it provides full insurance (ratherthan sharing risk with private mortgage insurers). This conclusion is based on what theauthors consider the most likely form of risk sharing agreements in which the PMIs are theprimary insurer “for mortgages that are traditionally insured under FHA’s full insuranceprogram”. This means that the PMI company would underwrite and service the loans,including claim processing and property disposition, reducing FHA’s administrative costs.The PMI would be in first-loss position, with a cap on total loss exposure. FHA would insureagainst large loss and only monitor the underwriting on an ex-post basis.

The PMIs have an information advantage over FHA and are private firms with differentobjectives than FHA. It is not necessarily in the PMI’s best interest to provide insurance tounderserved markets currently served by FHA mortgage insurance. Szymanoski and DiVenticonclude that in order to get PMIs to insure the same type of business that FHA currentlyinsures under its full insurance program, FHA would have to retain a large share of the loss.This is due to the large amount of uncertainty associated with lending in underserved marketsand markets with limited access to mortgage credit. As the uncertainty related to probabilityof default and severity of risk increases, FHA has to increase its share of each claim as well aslower the PMIs’ loss cap. This theoretical example suggests that, because the claims and lossuncertainty associated with the markets that FHA serves and the different incentive of a profitmaximizing firm compared to a government agency, the benefits of a risk sharing agreementwith PMIs does not outweigh the expected long-term costs to FHA. Consequently, “FHA fullinsurance may be preferred over risk sharing as a way to minimize its credit risk while fulfillingits basic mission” (p. 9).

One reason for this conclusion, which may initially appear to differ from some of the otherwork considered here, is that in the absence of PMI, it is assumed that FHA would not beaffected by information asymmetries or adverse selection. Instead of mitigating informationasymmetries, therefore, risk sharing with PMI has the potential to introduce them. This is


because of the high default and loss characteristics of the population served by FHA, and maynot be directly applicable to other segments of the mortgage market.


Sources Cited

Akerlof, George A., “The Market for ‘Lemons’: Quality Uncertainty and the Market Mechanism,”Quarterly Journal of Economics, 1970, vol. 84, 488-500.

Benveniste, Lawrence M. and Allen Berger, “Securitization with Recourse: An Instrument that OffersUninsured Bank Depositors Sequential Claims,” Journal of Banking and Finance, 1987, 403-424.

Carlstrom, Charles T. and Katherine Samolyk, “Examining the Microfoundations of market Incentivesfor Asset-Backed Lending,” Federal Reserve Bank of Cleveland Economic Review, 1993, Vol.29 No. 1, 27-39.

Cutts, Amy C., Robert A. Van Order and Peter M. Zorn, “Lemons with a Twist: Adverse Selectionand the Role of Securitization in Mortgage Market Evolution,” Freddie Mac Working Paper,December 1999.

Diamond, Douglas W., “Financial Intermediation and Delegated Monitoring,” Review of EconomicStudies, 1984, Vol. 51, 393-414.

Diamond, Douglas W. and Raghuram G. Rajan, “A Theory of Bank Capital,” University of ChicagoWorking Paper, October 1999.

Greenbaum, Stuart I. and Anjan V. Thakor, “Bank Funding Modes: Securitization versus Deposits,”Journal of Banking and Finance,” 1987, Vol. 11, No. 3, 379-401.

Hubbard, R. Glenn, Kenneth N. Kuttner and Darius N. Palia, “Are There ‘Bank Effects’ inBorrowers’ Costs of Funds?: Evidence From a Matched Sample of Borrowers and Banks,”Working Paper, June 7, 1999.

Jaffee, Dwight and Thomas Russell, “Imperfect Information and Credit Rationing,” Quarterly Journalof Economics, 1976, Vol. 90, 651-666.

James, Christopher, “The Use of Loan Sales and Standby Letters of Credit by Commercial Banks,”Journal of Monetary Economics, 1988, Vol. 22, No. 3, 395-422.

Leland, Hayne E. and David H. Pyle, “Informational Asymmetries, Financial Structure, and FinancialIntermediation, Journal of Finance, 1977, Vol. 32, No. 2, 371-387.

Passmore, Wayne and Roger Sparks, “Putting the Squeeze on a Market for Lemons: Government-Sponsored Mortgage Securitization,” Journal of Real Estate Finance and Economics, 1996,Vol. 13, 27-43.


Riddiough, Timothy J. “Optimal design and Governance of Asset-Backed Securities,” Journal ofFinancial Intermediation, 1997, Vol. 6, 121-152.

Stiglitz, Joseph E. and Andrew Weiss, “Credit Rationing with Imperfect Information,” AmericanEconomic Review, June 1981, Vol. 71, 393-410.

Spence, Michael, “Informational Aspects of Market Structure: An Introduction,” Quarterly Journal ofEconomics, 1976, 591-597.

Szymanoski, Edward J. and Theresa R. DiVenti, “Public Policy Issues if FHA Were to Enter Risk-Sharing Agreements with Private Mortgage Insurance Companies,” U.S. Department ofHousing and Urban Development Office of Policy Development and Research working Paper,January 23, 1998.

Townsend, Robert M., “Optimal contracts and Competitive Markets with Costly State Verification,”Journal of Economic Theory, 1979 Vol. 21, 265-293.

Vandell, Kerry, “Imperfect Information, Uncertainty, and Credit Rationing: Comment and Extension,”Quarterly Journal of Economics, 1984, Vol. 98, 841-863.


Appendix BInventory of Credit Enhancements

Below are various types of credit enhancements used by the GSEs, the Federal Home LoanBank System, and non-agency security issuers.

Bond insurance

Bond insurers, such as MBIA Inc. (MBIA), Financial Guaranty Insurance Company (FGIC),and Financial Security Assurance (FSA) insure bonds against possible losses. Wheninsufficient cash flow is generated from the underlying mortgages to pay the interest andeventually retire the bonds, bond insurers provide as much as 100 percent loss coverage.Bond insurance generally takes the second loss position and is frequently used with othercredit enhancements that provide first loss coverage, such as a reserve account orovercollateralization.

Cash collateral accounts

A type of reserve account financed by an institutional loan.

Corporate guarantee

A corporate guarantee is similar to a letter of credit in that the guarantor generally needs arating, at a minimum, equal to or higher than the highest rating of the securities. Thisguarantee is made by the issuer or third party to cover losses due to delinquencies andforeclosures up to the guaranteed amount.

Credit risk insurance

Insurance that covers losses on a pool of multifamily mortgages up to the dollar amount of thepolicy.

Cross-collateralization and cross-default

Cross-collateralization and cross-default, although not the same thing, are almost always usedtogether. This type of credit enhancement is frequently used when there is a single borrowerwith multiple properties. In cross-collateralization, a loss on one property is secured byanother property. Cross default means that if one property fails, then the servicer mayaccelerate the entire principal amount under any of the mortgages and may exercise itsremedies against any or all of the mortgaged properties. These credit enhancements deprivethe borrower of the option to selectively default, and give the lender or investor the benefit ofdiversification. This type of credit enhancement reduces expected loss, but if all of a


borrower’s properties become nonperforming, there is no remaining collateral to providesupport for the loan.

Deep/Supplementary Mortgage Insurance

Deep mortgage insurance works similarly to primary mortgage insurance, and is used tosupplement the coverage provided by primary mortgage insurance. For example, if primarymortgage insurance covers losses up to 30 percent of the unpaid principal balance of a loan,deep mortgage insurance may cover an additional 10 percent. It covers the second losses on asingle-family loan, after the primary mortgage insurance has been exhausted.

Hyper-amortization

Single mortgages or a pool of loans can be hyper-amortized, meaning that they are subject toan accelerated paydown of principal. When a security class in a CMBS is hyper-amortized,excess interest is applied to the class to pay down the principal ahead of schedule.

Letter of credit

A guarantee by a third party, typically a commercial bank, to cover losses due to default orforeclosure. The credit of the securities is enhanced by the credit quality of the letter of creditprovider, so the third party’s rating must be, at a minimum, equal to the highest rating of thesecurities. Letters of credit usually provide loss coverage after the reserve account isexhausted.

Loss sharing

Agreements that divide default-related losses from an individual mortgage or a pool ofmortgages between parties, for example mortgage sellers and the guarantor of the mortgageor mortgage pool.

Mortgage Insurance

For loans with down payments less than 20 percent of the value of the loan, lenders typicallyrequire mortgage insurance. This is the most common type of single family creditenhancement. Mortgage insurance covers losses up to a specified percentage of the unpaidprincipal balance at the time of default. Coverage varies depending on the LTV at originationand the amount of insurance purchased; however, a GE Mortgage Insurance rate plan showsthat coverage ranges from 18 to 35 percent for loans with LTVs over 90 percent, from 12 to35 percent for LTVs between 85 and 90 percent, and from 6 to 25 percent for LTVs of 85percent and under.

Overcollateralization

In a pool of securitized loans, the value of the security is smaller than the value of the principalof the loans backing it. In other words, the security contains more than adequate collateral tocover the debt.


Pool Insurance

Insurance that covers losses on a pool of single family mortgages up to the dollar amount ofthe policy.

Recourse

Recourse agreements assign default-related losses to one or more parties in a secondarymortgage transaction. Recourse is usually also involved in the case of misrepresentation orviolation of contractual agreements. The term generally describes a type of loan, whererecourse can either be to the borrower or to the lender. In a full recourse loan to the lender,the lender pays for all losses. In a full recourse loan to the borrower, the lender has a generalclaim against all of the borrower’s assets if the collateral is insufficient to repay the debt. Inpartial recourse arrangements, losses may be shared between two or more parties. In thiscase, the partial recourse is equivalent to a lender providing first loss coverage on a loan. Theterm recourse is sometimes used interchangeably with loss-sharing and risk-sharing.

Reserve Accounts

A reserve account is a type of escrow account, generally created with equity, cash-flowholdbacks, or sales proceeds. The proceeds of the account are generally used to cover lossesin the event of default over the life of the loan or pool.

Senior/Subordinated Structures

Cash flow generated by mortgages used as collateral is divided into groups, or tranches, tocreate securities of varying maturity and risk. Losses related to default are absorbed first bythe residual and subordinate tranches, reducing the credit risk borne by the senior tranche.

Spread Accounts

A form of reserve account used to capture the excess cash flow over the interest due on theMBS and servicing fees. Funds that build in spread accounts are used to cover losses frommortgage default as they occur.

Tiered primary mortgage insurance

A type of borrower-paid mortgage insurance in which the coverage provided by the insurer isstructured to better meet the investor’s needs related to risk-based capital requirements.


Appendix CAcronyms

COFI – Cost-of-Funds index

CMBS – commercial mortgage-backed securities

CRA – Community Reinvestment Act

DSCR – debt service coverage ratio

DUS – Delegated Underwriting and Servicing

FHLB – Federal Home Loan Bank

FHFB – Federal Housing Finance Board

FGIC – Financial Guaranty Insurance Company

FIRREA– Financial Institutions Reform, Recovery and Enforcement Act of 1989

FSA – Financial Security Assurance

GAO – General Accounting Office

PCs – Participation Certificates

GSEs – government-sponsored enterprises

LTV – loan-to-value ratio

LIBOR – London Inter Bank Offer Rate

MBIA – MBIA Inc.

MPF – Mortgage Partnership Finance

MPP – Mortgage Purchase Program

MBS – mortgage-backed security

OFHEO – Office of Federal Housing Enterprise Oversight

PMI – private mortgage insurance

REMIC – Real Estate Mortgage Investment Conduit

RMBS – residential mortgage-backed securities

SLC – Standby Letter of Credit

UPB– unpaid principal balance

WAS – Wisconsin Avenue Security

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