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Since 2008’s subprime mortgage meltdown, policy implementation, decentralizing risk, and correcting systematic issues continue today. One such instrument, Credit Risk Transfers (CRTs), which have an enigmatic backstory, have become a popular means of decentralizing credit risk while providing an avenue for institutional investors to diversify their agency mortgage loan exposure.

 

Despite subprime loan vintages’ derivative effect on the 2008 Financial Crisis, Fannie Mae and Freddie Mac both held most of this credit risk attributable to their purchases and securitization of loans from banks and non-bank lenders. Due to this centralized credit exposure, both agencies became forced to restructure into conservatorship or legally binding government sponsorship (GSE). Fannie Mae and Freddie Mac’s natural governing body became the Federal Housing Finance Agency (FHFA).

 

As a result of this new structure, Congress aimed to use these two agencies (Fannie and Freddie) to help the housing market through policy implementation. The investment instrument, CRTs, originated to reduce centralized agency credit risk exposure, while also mitigating taxpayers’ pass-through risk. To put it simply, a credit risk transfer or CRT launched as an instrument created to decentralize mortgage credit risk by transferring (allowing investors to invest in CRTs) a portion of the credit risk to private capital sources. Investors find this appeasing as these instruments diversify their holdings, while accommodating their credit risk exposure through relatively higher yields compared to agency mortgage-backed securities (MBS).

 

Freddie Mac issued the first of these instruments back in 2013 with Fannie Mae following closely behind. Today, most credit transfers are through Freddie Mac’s Structured Agency Credit Risk (STACR) and Fannie Mae’s Connecticut Avenue Securities (CAS). CRTs resemble unsecured debt obligations structured as credit-linked notes with different tranches making up the security’s skeleton. Lower tranches absorb losses first proceeding up the tier structure. Whereas upper tranches absorb prepayments first proceeding down the tier structure. CRT performance remains linked to a reference pool of loans that have been sold into agency MBS.

Credit Risk Transfer: Structure

These agencies pay interest on CRT notes, while also repaying the principle base on prepayment and credit quality of the underlying mortgage loans. CRT’s “credit catch” surfaces when credit losses or defaults of the underlying loans occur. In these cases, CRTs are written down and the agencies no longer have an obligation to repay the principal to investors. Thus, shifting the credit losses to the investors themselves. Therefore, though the loans remain agency-backed, the CRT instruments do not have any government guarantee.

Why would I invest in a CRT, pooled with agency loans, when the government does not back CRTs themselves?

 

The answer is simple. The high quality, strong credit borrowers making up agency mortgage loans are the same high-quality borrowers making up the loans securitized in the reference pool. Since 2008, underwriting standards of these loans improved with loan borrowers resembling relatively strong credit positioning compared to recent historical standards (higher FICO scores). Risk-averse structuring, lower interest rates (loans refinanced and taken out of CRT pools), and government intervention sharply lowers the risk of default of these underlying loans. The resurgence of the single-family housing market and the resiliency of the multifamily housing market amid economic uncertainty both remain prominent positive drivers.

Other monetary policy implementations, such as the Federal Reverse’s MBS purchase program and the CARES Act, indirectly supported these credit-linked instruments. Under the CARES Act borrowers in financial hardship can apply for mortgage forbearance (delay repayment for up to 12 months) without it counting as a default or hit to their credit quality. Forbearance’s hold up principle payments, but coupon payments continue. This could cause a situation where GSE’s (Fannie and Freddie) profit while investors incur the looming delayed losses from these forbearances. However, this likelihood remains debated as structural features reduce idiosyncratic disruptions. For instance, loans with greater credit risk profiles have a higher likelihood of entering forbearance. According to an S&P Global Credit Ratings’ test on the B-1 tranche “(assuming a 7.5% forbearance rate) approximately two-thirds of loans in forbearance would have to default at 20% loss severity to impair bonds (not including non-forbearance defaults).” Therefore, though this risk is evident it has some way to go before it becomes systematic.

Delinquency Rates in S&P rated CRTs:

March was something of a perfect storm for credit risk transfers. The coronavirus and the accompanied lockdowns caused fundamental housing market concerns amid high unemployment. This then led to the belief that mortgage rates will spike increasing delinquencies and defaults. It did not help that some investors leveraged their CRT positions due to their strong pre-COVID-19 fundamental drivers. As the economic stresses became prevalent, bond prices dropped while repo markets experienced a temporary liquidity crunch. This resulted in investor’s subjection to margins calls. Thus, forcing them to sell CRTs.

CRT’s drawdown exceedingly resulted from the fear of the uncertain. Since March, CRT prices recovered, fundamentals have improved, and spreads remain stretched to compensate for COVID-19 related headwinds.

What is the path forward for CRT’s?

Despite some signs of a recovery, a new issue arose: regulatory uncertainty. The CRT program remains the “lone wolf” as a non-politicized economic efficiency program. Unfortunately, this may not hold for long. In June, Director of FHFA, Mark Calabria, proposed a new GSE minimum regulatory capital requirement amid FHFA’s free-market (anti-conservatorship) leadership. This new anti-CRT biased capital requirement could cause the GSE’s to shrink, indirectly coining CRTs uneconomic. This has resulted in Fannie Mae not issuing any of these credit-linked bonds since the onset of COVID-19, accompanied with their pessimistic undertone of the market’s sustainability. On the other hand, Freddie Mac issued close to $3 billion in CRTs during Q3, with the first SOFR (2021 replacement to LIBOR) linked CRT issued this month (October 2020). Amid market indecision, it did not help that Mark Calabria shifted his tone explaining that CRT’s will remain economical (after capital requirement) for both agencies at a bipartisan House Financial Services Committee. This announcement heightened the uncertainty for these instruments.

It is debated that these securities will probably continue to benefit taxpayers whether these agencies remain in conservatorship. Additionally, the layered credit decentralization undertone used to minimize systematic credit risk remains robust. Statistically, with a higher probability of a blue sweep of administration, Mark Calabria could be removed, thus, stunting free-market ideologies. These outcomes are just speculation as it all remains hard to predict and continues to be a top priority that should be monitored throughout the year. We do believe that seasoned active managers can weather this CRT storm and provide competitive risk-adjusted returns. Overall, these assets have fundamental strength, good risk-bearing yield, and appropriate valuations; however, the regulatory uncertainty remains a wildcard for the market’s full recovery to pre-COVID levels.

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