Beginning in 2013, the two government-sponsored enterprises, Freddie Mac and Fannie Mae, began to change their business models to transfer to the private sector large amounts of the credit risk they generated in their securitization and guarantee business for single-family mortgages. This was done at the behest of their regulator, the Federal Housing Finance Agency (FHFA), which was and still is their conservator, giving it the power to direct the affairs of the two companies.

Almost immediately, the credit risk transfer (CRT) program became a core component of the GSE business model. Today, over six years later, more than 70 percent of the credit risk on new single-family mortgages is transferred to private market investors. Given that the two GSEs together have about $5 trillion of single-family mortgage credit exposure outstanding, this means very large amounts of risk are being transferred – something almost unimaginable when Freddie Mac introduced the first transaction as a somewhat experimental initiative in July 2013.

However, while it is easy to say the words “credit risk is being transferred,” what exactly does this mean? How does it work? Are there flaws or weaknesses in the transfer, making it seem better than it actually is?

In Demystifying GSE Credit Risk Transfer: Part II – How, and How Well, Does It Work?, I describe how CRT operates across four different types of financial transactions that are being used today to deliver the actual risk transfer. It is very much a case of “the devil is in the details” as it’s easy for a poorly-designed risk transfer transaction to turn out badly, with little risk having actually been transferred. And with no truly effective risk transfer, the five benefits listed in Part I of this three-part series will not be achieved.

In the new paper, I develop six key criteria by which to determine if a particular type of CRT is truly effective in transferring risk. I then assess how well each of the four types of CRT performs according to these six criteria. I also examine the transparency related to each type of CRT transaction, which turns out to vary widely.

My analysis shows that, for the four transaction types used currently to transfer risk, two seem to be doing the job well, one is so non-transparent that the public can’t come close to determining how well it works, and one has material weaknesses that should be addressed by the FHFA if it is to be allowed to continue.

Part III in the series (coming soon) will address what happened when CRT became embroiled in the well-known politicization of America’s system of housing finance and its continuing impact on housing finance policy.