Origin Credit Advisers’ Strategic Credit Fund is designed to offer investors a consistent stream of risk-adjusted income, appreciation and capital protection through credit investments—a form of debt financing that can pay off in higher-interest-rate environments and beyond. This Fund holds a combination of securitized products and direct loans backed by multifamily properties. Currently, high-yield agency mortgage-backed securities (AMBSs) issued by Freddie Mac comprise slightly less than 50% of its assets. These are rarely available to non-institutional investors, so we get many questions about what the agency is, why we can invest in Freddie Mac investment products and how the process works. Here are answers about this ongoing opportunity and how we secured it.
What is Freddie Mac?
In 1970, Congress created the Federal Home Loan Mortgage Corp. to increase the availability of funds and alleviate lenders’ interest rate risk in the secondary mortgage market. Both Freddie Mac and its sister agency, the Federal National Mortgage Association, or Fannie Mae, were founded to bring liquidity, stability and affordability to the mortgage market. And both are government-sponsored enterprises (GSEs), shareholder owned and traded on the over-the-counter market.
Freddie Mac and Fannie Mae support the housing market by buying about 70% of the mortgage loans made by private lending institutions such as banks and credit unions. Then they bundle these loans into pools of mostly similar loans or housing types—single-family, multifamily, student housing, mobile home parks and so on—and sell them to investors as AMBSs. This allows banks and credit unions to make more funding available for mortgage financing, which in turn stabilizes the housing market.
Though both have similar missions and are backed by governmental guarantees, there are fundamental differences. Fannie Mae was created in response to the Great Depression to offer more dependable funding for homebuyers. And it tends to buy loans from larger commercial banks and lenders. Freddie Mac was created when investors started buying and selling housing loans on the secondary mortgage market. And it usually buys single-family loans from smaller banks or credit unions and multifamily loans from pre-approved loan originators, which include some of the biggest lenders and brokers in the country.
Why Buy Freddie Mac Investment Products?
As a form of debt financing, agency mortgage-backed securities work like bonds and provide investors with a steady revenue stream from their income-producing assets. Typically, yields are higher than those paid by government bonds.
We wanted to take advantage of this type of real estate debt investment rather than common equity multifamily deals for several reasons. First, and most significantly, AMBSs offer less risk than equity investments. With equity, or ownership, in real estate assets, the upside can be high but so is the risk; this is the first position to take losses.
In contrast, the multifamily real estate credit that AMBSs represent is better insulated from loss. Equity investments act as a cushion “in front of” mortgage debt. If an asset loses value, the mortgage payments continue as scheduled. This debt investment will not be affected directly unless its equity is wiped out.
Sample Capital Structure
Freddie Mac’s bonds historically have had a low default risk because they must follow strict government-enforced lending guidelines. In comparison, the non-GSE MBSs typically pooled by banks or private corporations and sold on the secondary market are not always conforming, which means they do not meet the same stringent requirements of GSEs. Nor do they have governmental guarantees. For both reasons, they carry more risk (examples are jumbo loans or interest-only mortgages).
We also wanted to buy Freddie Mac AMBS products because their multifamily portfolio has a lower risk profile than high-yield corporate bonds, investment-grade bonds and the non-GSE MBSs discussed above. Their bonds have had a low historical loss rate of 0.04% since the program began in 1994. Current unlevered net yields on the Freddie Mac bonds in the Strategic Credit Fund range from 7% to 10%.1
When considering buying Freddie Mac agency mortgage-backed securities products—which have already undergone a stringent vetting process—purchasers can vet each underlying property in the portfolio with their own due diligence process. They can refuse the bond or ask for exceptions on properties they deem problematic. In our case, we also underwrite each loan in an AMBS using Origin Multilytics℠, a proprietary suite of machine-learning models.
Why is a Relationship with Freddie Mac Important?
Freddie Mac only offers GSE mortgage-backed securities to a few purchasers. Many are sold to major banks on the secondary market. But having ongoing access to these bonds to sustain the Strategic Credit Fund required us to be part of Freddie Mac’s rotation of purchasers, who are evaluated and chosen on a stringent set of criteria. Joining that rotation requires a firm to have a DCH, or Directing Certificateholder status, in order to buy Freddie Mac bonds directly on the secondary market. Only about 30 to 40 firms worldwide have a DCH, and only about 15 are currently part of the rotation and offered Freddie Mac AMBS products when they are released for sale.
When the agency has bonds to release, those bonds must be purchased expediently to keep the mortgage market running smoothly. And if a property in the bond pool experiences distress, the purchasers must be able to help resolve it—which may require cash.
Winning Approval to Purchase Mortgage-Backed Securities
Freddie Mac needs to know that purchasers have a solid track record of experience in financing and underwriting, asset management and remediating property issues. Before awarding a firm DCH status, the agency does extensive due diligence, which can be time-consuming and open-ended.
Freddie Mac purchasers generally must meet three stipulations. First, they must be active and successful multifamily owners and asset managers with experience as borrowers and lenders. Second, they must have significant knowledge of Freddie Mac products. And third, they must be able to make capital investments from $25 million to $65 million. These conditions eliminate 90% of potential buyers. Purchasers with DCH status who actively participate in the secondary market may get an offer to join an auction of agency mortgage-backed securities bonds. Bidders who win auctions join the primary rotation for future auctions.
Our parent company, Origin Investments, began cultivating a relationship with Freddie Mac in 2020 by introducing the agency to certain Funds managed by Origin Fund managers. These Funds were invited to join the auction bidding pool, but for several years, despite persistent bidding, none ever won an auction. However, that persistence showed a commitment to the Freddie Mac program and demonstrated that Origin Funds had consistent access to capital. The Origin Multifamily Credit Fund was awarded DCH status in 2021 after it co-invested in multiple Freddie Mac K-Certificates with a large multifamily asset manager that was already a DCH, and Origin’s Strategic Credit Fund continues to have that status.
How Freddie Mac’s Bond Buying Process Works
Currently, 12 to 17 groups participate in the purchasing program for Freddie Mac investment products, which works on a rotation basis. Three or four times a year, bonds are offered to each DCH holder at a set price that reflects their yields. Purchasers are assigned a spot in the lineup; Freddie Mac sets the bond price of the bond based on current interest rates, and the purchaser is offered a bond they must accept or reject. They have roughly three weeks to complete any due diligence.
Since each bond can hold dozens of mortgages, this can be a punishing process. To do proper due diligence, we must see every asset in person—the only way to identify property issues and potential remediation costs. We only had two weeks to vet the 51 properties across the country in one recent bond; in another, there were 21 properties. In the past, our due diligence has led us to decline some properties in a particular pool.
The Way Forward
This year, Freddie Mac is expected to top 2023 activity with a $70 billion FHFA (Federal Housing Finance Authority) cap on newly originated loans. We believe the vintages becoming available—with low loan-to-value ratios, reset property values and quality borrowers—are helping 2024 shape up to be a year of opportunities for the Strategic Credit Fund and its investors.
- For the performance information of the Strategic Credit Fund from which the above referenced return information was extracted, contact Thomas Briney at (800) 628-8008.