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A test of CRT liquidity in stressed markets

| March 13, 2020

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.

The market in Fannie Mae and Freddie Mac credit risk transfer securities has come through March so far as a steady and relatively liquid benchmark for pricing residential credit risk. Trading volume has surged, reaching more than 1% of the outstanding CRT float on some days. Anecdotally, trading in other credit markets has been uneven with a much smaller share of the float trading. CRT could come out of the current market volatility with new value for its ability to trade through stress.

Rising CRT trading volumes in March

The CRT market has traded heavily this month (Exhibit 1). According to TRACE, CRT trading volumes exceeded $700 million on several days during the week of March 2, representing more than 1% of the outstanding float changing hands. Volumes remain elevated during the week of March 9 with daily volumes exceeding $600 million and roughly $1.8 billion trading in the first three days of the week. The overwhelming majority of trading the week of March 9 has been in last cash flows with M2s making up more than two thirds of overall volumes and with B1s making up roughly 25 % of trades. M1 and B2s made up the remaining 8%.

Exhibit 1: CRT volumes surge in the face of spread widening

Note: Data through 3/6/2020 Source: Amherst Pierpont Securities

CRT often shows trading volume equal to or higher than other credit sectors. In February, average daily volumes in CRT represented roughly 0.5% the outstanding float, roughly double the relative liquidity in private label RMBS and investment grade credit. ABS and high yield credit demonstrated comparable if slightly lower liquidity. However, certain sectors of the ABS market, like shorter bonds backed by credit cards and auto loans can often be perceived as short duration, flight-to-quality cash surrogates, potentially buoying liquidity in stressed markets. Conversely, it seems likely that liquidity in high yield could become increasingly sparse. (Exhibit 2)

Exhibit 2: Comparing relative liquidity across sectors

Source: NY Federal Reserve, Amherst Pierpont Securities Observations through 02/26/20

The steady liquidity of CRT likely comes from the Federal Housing Finance Agency mandate that the GSEs transfer risk on a large swath of their guaranty book. As part of their annual scorecard, the enterprises need to transfer risk on 90% of their gross production that has a maturity of 25 years or longer and has a loan to value ratio between 60 and 97. The enterprises have multiple channels to lay off that risk to the market, either through capital markets securitization or syndicated or single-counterparty insurance contracts. Each of these channels provides benefits to the enterprises. Insurance capital may demand lower risk premiums given the fact that they can take somewhat of an actuarial view of the credit by participating in a steady stream of transactions. While capital markets execution allows the enterprises to spread risk across various sources of capital, reducing counterparty credit risk.

Liquidity also accrues to the profitability of the enterprises. The GSEs have significant incentive to maintain a functioning and relatively liquid CRT market even when the broader market is stressed. The enterprises by and large have to continue to transfer risk even through adverse market conditions, fundamentally making the asset class different from any sector dominated by private issuers. Dealers also have incentives to support primary issuance with steady secondary market trading.

Rising trade volume even as spreads widen

Spreads in CRT have widened materially in recent weeks as coronavirus driven risk-off sentiment has permeated almost all risk assets. Spreads on CRT have widened by anywhere from 30% to 50% across the capital structure (Exhibit 3). The wider spreads reflect highly elevated prepayment risk on securities recently trading at premium prices coupled with broader macroeconomic concerns. Despite recent volatility, fundamentals appear strong, potentially creating an attractive entry point to add residential credit exposure.

Exhibit 3: Spreads on some classes of CRT have widened by as much as 50%

Source: Amherst Pierpont Securities, Bloomberg LP

Given current levels of volatility, liquidity will likely become a mounting concern for MBS and benchmarked portfolios. Better relative liquidity and strong fundamentals may ultimately have the effect of attracting more capital to CRT, away from other areas of fixed income.

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