An early read on CRT exposure to Hurricane Florence

admin | September 14, 2018

This document is intended for institutional investors and is not subject to all of the independence and disclosure standards applicable to debt research reports prepared for retail investors.

Hurricane Florence, which came ashore in North Carolina on Friday as a Category 1 storm with 90 mph sustained winds, could affect between 2% and 6% of the outstanding loan principal referenced by Fannie Mae and Freddie Mac credit risk transfers. Uninsured flood damage poses the greatest risk. The aftermath of Hurricane’s Harvey and Irma in 2017 suggests potential impact on the lowest-rated classes of these deals, although the GSEs can offer forbearance to borrowers for up to a year and deal provisions can prevent disaster related losses from being realized for up to 20 months in some cases, potentially softening the blow. Ultimate impact obviously will depend on storm path and severity.

High population areas inland from the North and South Carolina cost may be affected if Florence stalls over land until Sunday and causes catastrophic flooding. Hurricane warnings have been issued along the coastline as far south as Hilton Head Island, South Carolina, and as far north as Virginia, expanding the potential scope of affected areas.

Exhibit 1: Share North and South Carolina loans STACR, CAS reference pools

Source: Fannie Mae, Freddie Mac, 1010data, APS.

Relatively small collateral concentrations can have a disproportionately large impact on agency CRT securities. As of the August remittance, many CRT deals have concentrations of loans in the Carolinas greater than the principal balance of outstanding securities. Across Freddie Mac’s STACR shelf, the largest concentrations lie in the first deal backed by HARP loans and other deals exposed to high LTV loans. The highest concentrations of Carolina loans in Fannie Mae’s CAS program are in 2017- and 2018-vintage low and high LTV groups

Uninsured flood damage could flow through to CRT investors if it wiped out borrower equity or otherwise led to default and loss. Fannie Mae and Freddie Mac require homeowners to have insurance that usually covers wind and other forms of storm damage but often does not cover flooding. Homeowners in federal flood zones are required to buy flood insurance and other homeowners can, too, although it may or may not be adequate. The impact of uninsured flood losses obviously depends on LTV, with higher LTVs more sensitive to small losses.

Some investors assume that mortgage insurance covers defaults and losses driven by flood damage, but that is not the case. Per Fannie Mae’s ‘Hurricane Relief FAQs for Single-Family Mortgage-Backed Securities (MBS) and Credit Risk Transfer (CRT) Investors’ issued last year in the wake of Hurricanes Harvey and Irma, “If physical damage was the principal cause of the borrower’s default, then the claim can be denied by the mortgage insurer in full.” Absent additional flood insurance, mortgage insurers should be within their contractual rights to deny coverage where flooding is the primary cause of the physical damage and subsequent default.

Additionally, the enterprises do not step in to cover claims denied by mortgage insurers if physical damage caused the borrower default. Per the CAS 2016-C05 prospectus the “Mortgage Insurance Credit Amount” with respect to any Credit Event Reference Obligation is the full amount, if any, that may be claimed as contractual proceeds of any mortgage insurance covering such Reference Obligation at the time such Reference Obligation became a Credit Event Reference Obligation, without regard to whether such amount or any portion thereof is actually received by or reimbursed to Fannie Mae from the applicable mortgage insurer, servicer or any other source. This language, and comparable language in Freddie Mac’s STACR prospectuses, effectively alleviates the GSEs from any responsibility to backstop the MI coverage since payment wasn’t covered by the mortgage insurance master policy. The net result of this would likely be not only increased probability of default given higher LTVs but greater loss given defaults absent the MI coverage.

The hurricanes that hit Houston and Miami last year offer some guidance. CRT transactions with the most exposure when the hurricanes hit show that those MSAs have contributed a meaningful percentage of loans 60 days or more delinquent as of August. Nevertheless, overall delinquency rates are contained. Despite a disproportionately large concentration of loans in these MSAs, average delinquencies across the 10 deals with the largest concentrations averaged 56 bp, suggesting that Hurricane Florence could add nominally small amounts to delinquencies or defaults in deals with the greatest concentrations of these loans.

Exhibit 2: Revisiting performance on CRT with concentrated hurricane risk

Note: Deal exposure as of 9/17 shows exposure to Houston and Miami MSAs. The columns labelled ‘Houston’ and ‘Miami’ each show the percentage of 60-day+ delinquencies contributed by each MSA. Source: Bloomberg LP, APS.

While the absolute amount of serious delinquencies in deals exposed to 2017’s hurricanes remains low and the contributions from Houston and Miami modest, the impact on CRTs once losses are realized could be material, especially in classes that absorb the first dollars of loss or the dollars that come shortly afterwards.