California wildfires light up exposures in some PLS and CRT

admin | November 1, 2019

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. This material does not constitute research.

Recent California wildfires have highlighted geographic concentration risk in some private MBS and GSE credit risk transfers. While the broad exposure seems modest, certain legacy transactions with only a few loans left have concentrated risk to the fires. And given structural leverage in the GSE transactions, even small exposures may signal meaningful risk. Limited disclosures across certain private MBS 2.0 shelves and GSE transactions add to the risk, too.

Kincade and Getty

There are two current uncontained wildfires affecting northern and southern California. The Kincade fire has affected areas north and west of Sacramento. The Getty fire has affected areas west of Pasadena in Los Angeles County all the way out to the Pacific Coast. According to CBS News, the Kincade fire has burned over 76,000 acres and is approximately 45% contained while the Getty fire has burned 745 acres and is only 27% contained. Given the far greater population density in Los Angeles County, the Getty fire, while far smaller, has potential to generate greater losses.

Fire damage is largely covered by most conventional homeowner’s policies, unlike flood or earthquake damage. However, wildfire coverage may vary by policy and whether the insured is in a high risk zone. Additionally, insurance will only cover up to the policy limit, and underinsurance is a potential source of loss. According to an analysis from the California Department of Insurance, wildfires generated nearly $8.5 billion of direct incurred losses to residential properties in norther California in 2017. As of that December, only $2.9 billion or just over one third had been paid. While fire damage may be covered, insurance may fall well short of covering all losses.

Implications for PLS

Approximately 16 ZIP codes look likely to be affected by the Kincade fire and 33 ZIP codes by the Getty fire. Private MBS has more exposure to the Getty fire than the Kincade one. An analysis of nearly $500 billion of legacy and 2.0 private MBS across more than 5,200 trusts suggests that overall exposure is fairly negligible. The selected universe has 16 bp of exposure to the northern California wildfires and 112 bp of exposure to the southern California, or just over $6 billion of total exposure. Assuming all the properties in the 49 zip codes were affected, it would generate just over $6 billion in losses. Applying the loss severity of roughly 66% experienced in 2017 would translate to just over $4 billion in losses across the entire universe, a fairly negligible amount.

Certain seasoned low-loan count trusts do have outsized concentration risk relative to the universe. These deals are largely localized to earlier vintages, and the top 25 impacted trusts only account for $250 million of unpaid principal balance across our universe of nearly $500 billion. (Exhibit 1) While the exposure seems small, there is a risk it may be understated; certain 2.0 issuers, specifically JP Morgan, do not disclose loan-level ZIP codes for collateral backing their post-crisis deals.

Exhibit 1: PLS trusts with concentrated risk to California wildfires

Source: Amherst Insight Labs, Amherst Pierpont Securities

Implications for CRT

Catastrophic risk is nothing new to participants in Fannie Mae and Freddie Mac’s respective credit rsk transfer programs. And while losses associated with natural disasters have been negligible to date, they continue to pose a risk to investors. Given the attachment point at which investors begin providing loss coverage to the GSEs, coupled with the structural leverage of the transactions, small exposures to areas affected by natural disasters and losses associated with those disasters may have a disproportionately large impact to bondholders. Disclosure, or more specifically the lack thereof, also poses a potential risk as the GSEs only provide a three digit rather than five digit ZIP at the loan level.

Deals with higher concentrated risk to the wildfires are largely seasoned de-levered CAS and STACR transactions, which have built credit enhancement as the deals have paid down. Despite the deleveraging, the wildfires may pose some risk to certain 2014 and 2016 vintage CAS deals as well a few STACR deals across the 2013 and 2015 vintages. (Exhibit 2)

Exhibit 2: Estimated CRT exposure to California wildfires

Source: Fannie Mae, Freddie Mac, Amherst Pierpont Securities

For example, CAS 2014-C03 Group 2 has the largest estimated exposure to the recent spate of fires, totaling 9.8%. The 2M2 bond has 1.28% credit enhancement and is just under 2.5% thick. If 20% of the loans in affected ZIP codes were to ultimately default at a 65% severity—consistent with loss severities on claims published by the state Department of Insurance in the wake of the 2017 fires—the 2M2 bond would begin to take losses. However, history does not support this type of draconian default scenario. Past natural disasters have caused a massive spoke in delinquencies, but those delinquencies tend to abate to normalized levels within a year of the disaster. The Enterprises generally have provided hardship forbearance to borrowers in affected areas, which has helped mitigate large scale defaults, and, to date, natural disaster related losses have been minimal. However, past is not always prologue and investors should remain attune to potential losses until the fires are contained and total losses assessed.