just as the GSEs have always been, ergo its creation would not address any issues of obsolescence. Treasury would only continue to wear the type of systemic risk it did prior to the financial crisis. On Feb. 28th, at a meeting with a new team of senior capital market and housing finance policy analysts at Treasury, I presented evidence of their continued acceptance of, and sensitivity to, systemic housing market risk. Initial reactions suggested belief that, given popular academic forecasts for upward trending housing prices, systemically important financial institutions were adequately capitalized against future housing price shocks. As such, there was little concern for additional near-term Treasury bailouts. However, upon further discussion it was realized that reliance on housing price forecasts from entities without skin in the game is inconsistent with DFAâ€™s declaration of financial stability through accountability and that Treasuryâ€™s responsibility goes beyond supporting only short-term recovery efforts. It was advised that for longterm stable economic expansion Treasury should be studying and advocating for the creation of a capital market for housing prices. A week later, after relaying to Freddie Mac the discussion points covered with Treasury, they conveyed to me that they were focusing on a creditlinked note (CLN) strategy, as opposed to the contingent capital strategy at the heart of our prior joint study, for the purpose of satisfying their risk sharing quota placed upon them by FHFA. The prioritization was, or is, based on perceived â€œincreased hedge effectiveness and reduced basis riskâ€? which would seem to be at odds with both the results of our earlier study on the matter and FHFAâ€™s own suggestion the previous year that housing price indices were the simplest and most direct measure of risk in the mortgage market (the contingent capital strategy relied on housing price indices as the triggering mechanism). CLN on the other hand, in this context, are a type of residential mortgage-backed security (RMBS) where an institutional counterparty, like Freddie Mac, â€˜promisesâ€™ to pay bond investors monies related to the performance of mortgage loans, where the loans themselves are not actual collateral to be held for the benefit of the bond investor. CLN were discussed briefly within the BPC report as a source of private credit enhancement and, though never used by the GSEs in the past, were used extensively by the private capital markets, especially banks, prior to the financial crisis. As they embed a level of counterparty risk on top of what RMBS already possess, the suitability of such a risk sharing process must be carefully analyzed as to avoid to their contributing certain risks to the overall financial system as detailed in the FCIC report. The following June, a draft of the Housing Finance Reform & Taxpayer Protection Act is released. This GSE reform bill is centered on the creation of a Federal Mortgage Insurance Corporation (FMIC) which will, as recommended by the BPC, replace the GSEs with a single U.S. owned corporation that will provide government guaranteed catastrophic mortgage insurance. That same month, Credit Suisse Group AG downgraded a large reinsurance company called Validus Holdings Ltd. Credit Suisse based its decision on the fact that Validusâ€™ insurance company clientele were moving toward the use of contingent capital instruments as a more effective way to manage their weather-related catastrophic property risks. This re-raises the question of the appropriateness of creating an insurance company, such as the FMIC, which is meant to handle catastrophic systemic risk while only being capitalized to handle diversifiable risks, when the private insurance markets themselves have recognized the inadequacy of that business model for such a task. It also suggests Congress and the Administration should revisit and refine the idea of contingent capital as a basis to privatize systemic risks. In July, Freddie Mac released the offering documents for its new risk sharing bond, a CLN called Structured Agency Credit Risk (STACR) securities. These documents describe how only hypothetical loan losses are to be shared with STACR bond investors, not actual losses, by establishing pre-set loss amounts for any loan that defaults based solely on the overall level of defaults within the reference portfolio, regardless of how, for example, housing prices fluctuate in the future. Though Freddie Mac has met the strict interpretation of FHFAâ€™s quotas for risk sharing it has also, by divorcing housing prices from mortgage risk, impeded regulators from gaining private market substantiation of their hypothetical forecasts of a critical measure of systemic risk. Another feature of this structure is that it will give Freddie Mac an actual profit on every loan that defaults which does not experience a loss as severe as was pre-set, when, for example, housing prices are stable or increasing. This creates an odd incentive given, as written in the STACR offering circular, â€œFreddie Mac does not re-underwrite the mortgage loans it acquires from its sellers, which may adversely affect the performance of the reference obligation.â€? Without retaining any accountability for the loans it is insuring or securitizing there can only be greater performance instability in those loans, per DFA, which suggests that Freddie Mac is currently engineered to speculate on the price appreciation resulting from the Administrationâ€™s steps to affect a short-term economic recovery. Thatâ€™s the type of pro-cyclical feedback loop that may not be consistent with the Pecora Committeeâ€™s suggestion for the continued on page 86 59 Markets may be volatile, but thereâ€™s one thing you can always count on, the total commitment of our Mor tgage Team. 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