The federal government is trying to get taxpayers off the hook for billions of dollars of potential losses if another mortgage crisis arrives—and in the process, it is quietly giving birth to a new asset class.

Under government control, mortgage-finance giants Fannie Mae and Freddie Mac next year plan to ramp up sales of new types of securities that in effect transfer potential losses in a housing downturn to private investors.

Called Connecticut Avenue Securities by Fannie Mae and Structured Agency Credit Risk by Freddie Mac, the securities are essentially bonds whose performance is tied to that of a pool of mortgages. If the mortgages default, investors in the bonds could lose some or all of their principal.

Proponents of the risk-transfer deals see them becoming a mainstay of the bond and housing markets over time, perhaps even entering major bond indexes tracked by mutual funds and exchange-traded funds.

The sales are especially notable because issuances of private-label mortgage-backed securities, which also give private investors mortgage exposure, are still moribund.

"To many people, mortgage credit risk is still a bad word," said Laurie Goodman, director of the Housing Finance Policy Center at the Urban Institute, adding that she isn't optimistic that the market will revive soon.

But to the extent that yield-starved investors do want to take on such risk, Fannie's and Freddie's new securities are the only outlet.

"Right now, the [transactions] are almost the only way for investors to get exposure to new residential mortgage-credit risk," said Steven Abrahams, a mortgage analyst for Deutsche Bank AG.

Fannie and Freddie already have sold about $25 billion of securities since 2013 to private investors, including money managers such as BlackRock Inc. and Invesco, hedge funds, real-estate investment trusts and other investors.

Earlier this month, the Federal Housing Finance Agency, which regulates Fannie and Freddie, said the companies would transfer to private investors in 2016 the credit risk on 90% of the unpaid principal balance of the riskiest mortgages the companies back—where homeowners get a mortgage of more than 20 years and make less than a 40% down payment.

Fannie and Freddie don't make loans. They buy them from lenders, wrap them into securities and guarantee to make investors whole if the mortgages default.

In practice, that has meant that investors have taken on the risk of losses if interest rates rise, but have left the government with the risk if borrowers default. The new securities—along with other methods Fannie and Freddie use to lay off risk—mean that the government is increasingly transferring that default risk to private investors as well.

For example, in June Freddie Mac sold $950 million of the securities covering $18.4 billion of Freddie-backed loans. If a severe housing downturn emerged in a few years, those mortgages could be expected to suffer a 2% loss, said Moody's Analytics chief economist Mark Zandi, hitting Freddie with losses of $368 million without the protection. Instead under the terms of the June deal, Freddie would lose only $143 million, while the private investors would lose $225 million, Mr. Zandi said.

In exchange for taking that risk, in that deal investors got yields of between 1.15 percentage point and 7.55 percentage points above a benchmark short-term interest rate.

Some market watchers note that the companies' programs are still nascent and that the market has yet to show how much appetite it has for the new securities. Fannie's and Freddie's early deals only protected them from losses beyond a certain level, though the companies have begun to sell "first-loss risk" as well.

"We're going from no place to some place," said Lewis Ranieri, the financier who co-invented the mortgage-backed security. "There's still a question of whether [the securities sales] can be expanded to really provide the goal of making the government the guarantor of last resort."

Among other outstanding questions are at what price investors will buy the securities in times of market stress and how much issuance it will take until the securities, which now are structured as Fannie and Freddie corporate debt, easily trade on the open market. Right now, the debt trades infrequently and tends to stay with the investor who first bought it. New capital standards have caused banks to pull back from dealing in all sorts of bonds, cutting off that avenue for trading as well.

Although BlackRock has bought portions of the Fannie and Freddie deals, it has done so on a limited basis, said Kevin Chavers, BlackRock's managing director on a panel this month hosted by the Securities Industry and Financial Markets Association, a trade group.

BlackRock's "primary concerns are the lack of liquidity in that marketplace and the lack of liquidity is largely driven by the capital requirements that dealers are required to maintain," Mr. Chavers said.

Hedge funds and money managers have made up the bulk of the earliest investors, with REITs, banks and insurance companies participating to a lesser extent.

Over the next year, proponents of the risk-sharing deals hope for the development of some of the features of a more mature market. New York-based Vista Capital Advisors, a financial-products company specializing in the corporate bond market, hopes to release indexes based on the Fannie and Freddie bonds early next year, said Richard MacWilliams, managing partner at Vista.

Vista hopes to release products later in the year based on the indexes that would allow investors to trade Fannie's and Freddie's credit risk more easily, Mr. MacWilliams said.

Write to Joe Light at joe.light@wsj.com

 

(END) Dow Jones Newswires

December 29, 2015 06:15 ET (11:15 GMT)

Copyright (c) 2015 Dow Jones & Company, Inc.
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