SAN FRANCISCO - The largest public housing finance agency in the country has stopped most mortgage lending and is working to deleverage its balance sheet to help it weather the sharpest housing downturn in its three decade history.

The California Housing Finance Agency's survival strategy shows how mutually reinforcing credit and economic crises can force even a public agency - whose mission is to lend and to help solve problems like the housing crisis - to curtail lending at the worst possible time for consumers and the economy.

CalHFA, which borrows money in the tax-exempt municipal bond market to fund mortgages for first-time homeowners as well as for multifamily housing, has been hit by both the downturn in the housing market and the freezing of the credit markets.

It faces the threat of a credit rating downgrade from Moody's Investors Service and must deal with a half billion dollars of bonds that have been put back to its liquidity banks, forcing the agency to focus on its balance sheet rather than lending to creditworthy borrowers who have been caught up in the mortgage crisis.

"Out of necessity, CalHFA has recently restricted, and in some cases suspended, loan programs while focusing attention on a variety of challenges presented by the credit, financial and real estate markets," said chief financial officer Bruce Gilbertson. "Reduced lending activity in the near term and continued concentration on market dislocations will better position the agency to finance affordable housing initiatives in the future when market conditions improve."

Like all California lenders, the HFA has seen defaults rise sharply as the state's housing market has cratered, but its defaults on uninsured mortgages remain low, especially compared to subprime lenders.

While the agency lends to first-time homeowners with small down payments, CalHFA officials say the agency is no public-sector IndyMac Bank or Countrywide Financial. It required solid credit scores and documentation of incomes for mortgages.

About 3.3% of the agency's home loans were delinquent by 90 days or more at the end of September, up from just 1.3% a year ago, according to its most recent delinquency report. By comparison, the Mortgage Bankers Association this month said that 19.6% of U.S. subprime mortgages and 2.9% of prime loans were delinquent by three months or more at the end of the third quarter.

CalHFA suffered $294,073 of uninsured losses on 55 foreclosure sales in the first 11 months of 2008, and it currently holds 220 foreclosed properties that are for sale, according to the delinquency report.

"The losses aren't huge today, but we are expecting them to grow," Gilbertson said.

The biggest problem for CalHFA is not that mortgages are going bad in large numbers. Rather, the problem is the frozen credit market, particularly the dislocation in the variable-rate muni bond market.

CalHFA has about $4 billion of variable-rate bonds in its $8.4 billion portfolio of outstanding debt. The agency has seen hundreds of millions of dollars worth of bonds put back to liquidity banks because investors are worried about the banks' credit. It had $567 million of bank bonds as of Dec. 11.

Variable-rate demand obligation holders have the right to demand repayment for their bonds on short notice, and municipal issuers use bank standby bond purchase agreements or letters of credit to provide the liquidity in case of such puts. When investors fear a liquidity bank or insurer is in trouble, they can put their bonds, forcing bond issuers to pay penalty rates and to repay debt on an accelerated schedule. CalHFA's bank bond inventory was down by about half from mid-October, but still represented about 14% of its variable rate portfolio.

As of early December, the problem bonds broke down into two categories - the agency had $902 million of VRDOs insured by MBIA Insurance Corp., Financial Security Assurance Inc., or Ambac Assurance Corp. It also had $924 million with liquidity from Dexia Credit Local or Depfa Bank NA. The three insurers and the two liquidity banks have been downgraded this year, reducing investor appetite for securities with their backing. Some of the debt falls into both categories.

The vast majority of CalHFA's bank bonds carry liquidity from Dexia or Depfa. Its insured debt tends to remarket successfully, but the agency has been forced to pay a premium to convince investors to buy it. The agency paid an average interest rate of 2.5% on its variable-rate debt in the month before Dec. 11. That's roughly twice the Securities Industry and Financial Markets Association swap index's average over the same period.

The stresses buffeting the agency convinced Moody's to put the agency's Aa3 general obligation bond rating under review for possible downgrade in late September. The rating agency said Dec. 28 that the bonds remain under review.

"This action was based on the combined effects of increased losses from delinquencies and foreclosures from single-family mortgages, heightened risk related to the agency's variable-rate debt resulting from a volatile market and counterparty risk, and a lending initiative that had placed additional leverage on the agency's balance sheet," Moody's said.

The review includes about $1.4 billion of GOs and more than a billion dollars of multifamily housing bonds that are backed by the agency's GO pledge. The review doesn't include the bulk of the agency's debt, which is sold under its Aa2-rated home mortgage revenue bond program.

Gilbertson and the HFA are taking extraordinary measures to reduce the agency's exposure to the variable-rate market woes and to maintain the GO credit rating at a double-A level. If the agency loses its double-A level rating, it would face the loss of money-market investors on some of its variable-rate debt, forcing more debt back to banks.

To decrease leverage, the agency recently offered to sell more than 13,000 single-family home loans worth $2 billion and 70 multifamily home loans worth $280 million to Fannie Mae and Freddie Mac, the federal government's housing enterprises. It also plans to offer the mortgages to commercial banks, as it seeks to raise capital to pay off variable-rate debt that is not performing well. The agency expects to raise as much as $600 million to $700 million by selling loans.

"To the extent that we're successful selling loan assets, we're going to deal with" Dexia-backed debt, which accounts for the bulk of the agency's bank bonds, Gilbertson said. The agency is also considering using some of its $470 million of cash to pay down its worst-performing debt. It has already redeemed about $50 million of Depfa-backed debt.

The HFA plans to unload the $100 million obligation resulting from the "lending initiative" that Moody's said had added leverage to its balance sheet. Gilbertson admits the loans are unusual, but doesn't think they're particularly risky.

The loans finance the construction of group homes for developmentally disabled adults who are being de-institutionalized from a state hospital in the San Francisco Bay Area. The state of California is the ultimate payer of the mortgages, but since Moody's sees them as a risk, the HFA plans to sell the loans or to spin them off into a separate indenture that's not backed by the agency's GO pledge.

The agency is also moving on multiple fronts to repair outstanding debt that can be fixed. This week it stripped the MBIA insurance from $53 million of outstanding VRDOs and remarketed them without insurance. The conversion lowered the rate on the debt to 1.1% from an average of about 5% in December. The HFA plans to strip the insurance off another $82.5 million MBIA-backed VRDOs next week.

CalHFA changed remarketing agents on $1 billion of debt since September, in some cases assigning remarketing responsibilities to the liquidity banks that back the bonds.

"If they don't successfully remarket, they're buying the bonds themselves," Gilbertson said. The goal is "to put bonds with a remarketing desk that will actively try to deal with them."

CalHFA in November terminated Lehman Brothers swaps with a notional value of $482.7 million. That cost the HFA $42.5 million in termination fees. It replaced Lehman as the counterparty on another $340 million of swaps. Goldman Sachs and Deutsche Bank are its new counterparties.

Over time, Gilbertson said the agency also aims to reduce its variable-rate exposure and dependence on external credit support. It is de-leveraging to take out badly performing variable-rate debt, but Gilbertson said the agency will be back in the market in a big way when it can get better access.

The agency recently received $860 million of additional private-activity bond volume cap under the housing rescue plan passed by Congress last summer. That boosts the agency's total available authorization to $1.6 billion.

"When the market comes back to us, we are going to be well positioned to issue," Gilbertson said.

In the meantime, CalHFA also hopes to restart its lending programs next month with loans that it can sell to the federal government sponsored enterprises. He said details of that new program should be announced sometime later this month.

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