U.S. Government Agencies Create New Mortgage Derivatives

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Two mortgage firms largely under government control create a new financial instrument similar to those that caused the global financial crisis of 2008.  Fannie Mae and Freddie Mac, two mortgage loan companies that provide government-guaranteed mortgages to American homebuyers, announced a new financial instrument that it hopes would offset risks in the financial market.

Both firms, which are government-sponsored enterprises, are producing two new derivative instruments based on collected mortgages that will theoretically reduce risk to American taxpayers.

Some financial analysts, however, warn that these instruments could easily have the opposite effect, not unlike the mortgage-backed securities (MBS) that lay at the core of the 2008 housing meltdown and ensuing global financial crisis from which the world has still not recovered.

CAS and SACR Products for Sale

Fannie Mae will release a new product called “Connecticut Avenue Securities” (CAS) and Freddie Mac will release a product called "Structured Agency Credit Risk” (SACR). These products securitize existing mortgages for sale to speculators.  Both securities, while extremely complex, will effectively go up in value when people default on their mortgages.

A Repeat of 2008?

Proponents of the products say the lack of leverage in these products would make them less toxic than the MBS of the past. Critics however, point out that, by allowing the transfer of risk of originating mortgages to a second buyer, this instrument will incentivize Fannie Mae and Freddie Mac to approve riskier mortgages that have a higher chance of default.

In this case, the losses that an investor could make would be severe. If defaults rose to 5.67 percent, as they did at their height in 2009, then an investor would lose 74 percent of its initial investment. This level of losses at banks could cause a lack of liquidity that, in turn, could cause an investment bank to collapse, as was the case with Bear Sterns and Lehmann Brothers in 2008.

Lending standards

In part, the move is an attempt to encourage looser lending standards, and is part of several initiatives by both Fannie and Freddie as well as by the Federal Housing Administration, which are working to encourage private banks to offer higher loan-to-value loans as programs such as HARP and similar programs are set to expire in 2016.

Government-sponsored lenders are looking at additional means to transfer credit risk to the private market, and some experts believe more derivative instruments like the CAS and SACR products will likely be unveiled to the market in the next year.