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Unpacking recent cash flow events in GSE CRT

| January 22, 2021

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.

In most mortgage credit bonds, fast prepayments generally help mezzanine and subordinate bond holders. Speed deleverages the structure, increasing the amount of credit support to mezzanine bonds as more senior ones pay off. But fast prepayments in loans referenced by Credit Risk Transfer securitizations are, in some cases, generating a different outcome.

At issue is the way CRT deals calculate whether a class will get no principal, only scheduled principal or both scheduled and unscheduled principal. In all CRT deals the trigger depends on the ratio of a distressed principal balance to the total balance. The distressed balance can be defined as simply delinquent loans or both delinquent and modified loans. As borrowers cure and exit hardship forbearance, the decline in delinquent loans should reduce the distressed principal balance and allow these deals to begin receiving principal allocations again.

However, this may not always be the case if the amount of loans prepaying drives the total balance down faster than the distressed balance. One example of this can be seen in the two 2018 Freddie Mac high LTV (HQA) transactions. The balance of delinquent loans fell from $3.66 billion in September to slightly more than $3 billion as of December, a roughly 18% decline. However, when measuring delinquencies as a percentage of outstanding balance, that nominal change represented just a 20 bp decline over the same period, falling from 8.32% in September to 8.12% in December. This represents just a 2.4% decline in the delinquent balance a percentage of the overall balance despite a much larger absolute decline (Exhibit 1).

Exhibit 1: A case study in elevated delinquency calculations – STACR 2018-HQA

Source: Freddie Mac Clarity, Bloomberg LP, Amherst Pierpont Securities

This example broadly illustrates the potential impact of elevated prepayments on delinquency triggers across CR. The effects will differ across CAS and STACR bonds depending on the status of delinquent loans, and differences may be even more pronounced in REMIC versus non-REMIC structures.

The biggest potential offset to extension risk associated with delinquencies declining more slowly than total balance can be found in CAS and STACR REMIC transactions. These include a structural feature called the Supplemental Subordinate Reduction Amount. The SSRA is tantamount to a maximum credit enhancement test. This feature allows both CAS and STACR bonds to receive scheduled and unscheduled principal if outstanding CRT as a percentage the reference pool balance meets a certain threshold. In that instance, the amount of unscheduled principal greater than the target percentage will be allocated to the senior-most bond remaining in the capital structure. This effectively turbos down the most senior bond that would have otherwise been locked out. The SSRA should help mitigate extension risk, specifically on mezzanine classes of deals with this feature. If delinquency percentages are sufficiently elevated to lock out the structure, fast prepayments will continue to reduce the reference balance, increasing the ratio of outstanding CRT bonds relative to that balance, allowing the deal to reach its SSRA target and subsequently resume paying principal to the senior-most outstanding bond.

An analysis of REMIC transactions shows that some of these deals have already exceeded their threshold tests to resume principal payments, while many others appear poised to breach those thresholds in the coming months assuming prepayments remain elevated (Exhibit 2).

Exhibit 2: Stacking up SSRA levels across REMIC CRT

Source: Bloomberg LP, Amherst Pierpont Securities SSRA threshold is calculated as a function of Offered Reference Tranche percentage. Adjusted SSRA is reflects the level at which the subordination percentage is sufficient to override failing principal triggers. Adjusted SSRA is calculated by increasing the SSRA threshold by the thickness of the B2H/B3H first-loss tranches which are retained by the Enterprises

The increased incidence of permanent loan modifications could further exacerbate the trigger lockout issue, particularly in 2018 and earlier vintage Freddie Mac STACR transactions. The calculation of the distressed principal balance in STACR deals differs from Fannie Mae CAS deals in that it includes the rolling 6-month average of 60+day delinquent loans and loans modified in the past 12 months along with later-stage delinquencies, foreclosures and REOs in their calculation of the distressed balance. CAS deals do not include modifications or early-stage delinquencies in their calculation. If prepayment rates remain elevated and the balance of modified loans increases, then despite those loans rolling back to current post-modification, they will continue to be included in the distressed STACR principal balance for a year post-modification.

Currently this is not an issue. According to Freddie Mac Clarity data, only 338 out of more than five million active loans referenced in STACR trusts were permanently modified in December. And the implementation of payment deferrals to maturity on arrearages incurred during hardship forbearance may limit the need for permanent modification. With that said, historically, the longer a borrower goes without making a payment, the greater the likelihood they will require some type of permanent modification. And given that hardship forbearance plans will be coming to the end of their terms in the coming months, it’s possible that population of modified loans in these deals may begin to increase over the next several months.

A locked-out silver lining?

Lockouts are generally a bad thing, but lockouts may not be all bad for CRT investors, especially those further down in the capital structure. As delinquency triggers have been tripped, redirecting principal to the senior reference tranche, these deals have both built credit enhancement and provided bondholders with incremental coupon income to help offset potential future losses. Ultimately, investors in the bottom of the capital structure in CRT will be exposed to a small population of the worst performing borrowers. Despite deleveraging, these bonds may incur losses if the ultimate cumulative loss is greater than that of the first loss tranche retained by the Enterprises at issuance. With that said, incremental carry that investors at the bottom of the stack have received on larger outstanding principal balances as a function of being locked out may serve to offset some of those potential losses.

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