Improving prospects of more CRT issuance

Chris Helwig | August 6, 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. This material does not constitute research.

The market for GSE risk transfer securities has evolved over the past year. Freddie Mac’s STACR program has responded to a shift in regulatory requirements and a change in fundamental risk in the wake of pandemic. Based on strong demand for the most recent STACR transaction, it appears these changes may pave the way for Fannie Mae to return to market sooner rather than later.

CRT investors have had good reason for concern about fundamental credit during pandemic, and along with that concern came new GSE capital rules that diluted the benefits of issuing CRT and led Fannie Mae to pull back. Today, the majority of concern around fundamental performance has abated as roughly two-thirds of loans in forbearance during the summer of last year have either re-performed or prepaid. And the recent appointment of Sandra Thompson as Acting Director of FHFA should improve the outlook for continued issuance of CRT as Thompson will likely have a different view on capital and more constructive view of the benefits of the programs.

Tracking the changing cost of risk transfer

The shifting fundamental and regulatory landscape for GSE CRT has driven structural changes to Freddie Mac STACRs. STACRs increased the loss absorbing capacity of first-loss securities retained by the by Freddie Mac and increased the thickness of subordinate bonds to provide more protection to mezzanine investors. More recent changes have focused on optimizing structures to be more efficient given the diluted capital benefit of issuing CRT and a broad-based increase in credit quality of loans purchased over the past several quarters. The net effect of improving credit quality coupled with optimizing structures has led Freddie Mac to transfer thinner collars of risk through their STACR programs than the GSE has historically. Structural changes, along with an overall flattening of the credit curve, have had had the effect of reducing the cost of risk transfer over time. (Exhibit 1)

Exhibit 1: Calculating the cost of risk transfer

Source: Bloomberg LP, Amherst Pierpont
Cost of issuance is calculated using pricing spreads, WAL and tranche thickness at issuance and is subject to change based on prepayments, deleveraging can losses applied to each pool

Pricing assumptions, spreads and structural leverage across the capital structure of deals at issuance imply a cost of credit risk transfer. As Freddie Mac has changed these structures over time, the cost of credit risk transfer has declined by almost two thirds, peaking at nearly 22 bp in their STACR 2020-HQA4 transaction and dropping to a low of 7.4 bp on the most recent STACR 2021-DNA5 transaction. The reduction in the cost of risk transfer has been primarily a function of Freddie Mac transferring thinner slices of risk as well as an overall flattening of the credit curve. In addition, the most recent Freddie Mac deal set the minimum credit enhancement threshold test at the detachment point of the senior-most M1 class of the deal, effectively making the structure open-pay immediately after issuance, curtailing the weighted average life of the structure and reducing the cost of credit risk transfer to the issuer. Comparing the pricing WAL of the most recent 2021-DNA5 transaction and the previously issued 2021-DNA3 deal shows that, after normalizing for a 2.0% detachment point on both deals, the open window structure reduced the WAL of the structure by 0.8 years. The cost of transferring the same slice of risk was roughly 2.5 bp less in the DNA5 deal, however that appears to be primarily a function of wider spreads on the DNA3 deal.

Setting the stage for more supply

Investor demand for Freddie Mac’s most recent transaction suggests the market may be ready to absorb increased supply of CRT as the deal drew 66 unique investors, according to Freddie Mac, the most in a STACR transaction since 2017. The B1 class alone drew 39 unique investors, the most for that class in a STACR deal ever despite it being the largest B1 class ever issued.

And there may be a substantial amount of contingent supply for the market to absorb as Fannie Mae has recently acquired nearly $1.2 trillion of loans where the agency has yet to transfer any of the credit risk. According to its most recent 10-Q filing, roughly one-third of Fannie Mae’s single family guaranty book, totaling $1.178 trillion in principal balance, has been acquired in the past two years and does not carry any credit enhancement. It appears that this balance represents CAS-eligible reference collateral as Fannie Mae makes additional disclosures for loans that fall out of the scope of the program due to maturity, LTV or coupon type. Assuming Fannie Mae were to adopt Freddie Mac’s most recent structure, transferring 175 bp of credit risk in the form of a four-tranche 0.25% to 2.0% corridor of risk would translate to just over $20 billion in notional risk transfer, which nominally does not seem insurmountable, but does represent roughly 50% of the current outstanding float of GSE CRT. Arguably, given the seasoning of the loans, subsequent home price appreciation and deleveraging via amortization, Fannie Mae may look to transfer even less than the 175 bp corridor of risk transferred by Freddie Mac, potentially reducing the amount of contingent supply.

These developments beg the question of when might Fannie Mae come back to market. There are likely two paths that may lead Fannie Mae back to issuance. One clear although long-dated path would be the implementation of new GSE capital rules that would replace the existing ones, increasing the capital relief associated with issuing CRT, potentially closer to the benefits garnered under the previous capital rule. However, the market may not have to wait that long. Under new leadership, FHFA alternatively could suspend implementation of the capital rule while it is being reviewed. There is existing comparable precedent for this as the Consumer Finance Protection Bureau delayed implementation of new Qualified Mortgage definitions and rules prior to implementation. If FHFA were able to stay implementation of the capital rules, the GSEs would likely revert to the Conservatorship Capital Framework in the interim. An adoption of the CCF would likely pave the way for increased CRT issuance sooner than would otherwise happen under a completely revised capital rule.