Credit Risk Transfers: Hot Topic of 2017

The Credit Risk Transfer (CRT) market continues to be a compelling investment vehicle that offers residential mortgage backed security (RMBS) investors an opportunity to achieve attractive risk-adjusted returns, while accessing various parts of post-crisis mortgage credit and origination. Following the mortgage crisis, the Federal Housing Finance Agency (FHFA) has mandated a number of changes affecting the government-sponsored enterprises (GSEs), mainly Fannie Mae and Freddie Mac, reducing the risk of losses that the GSEs may pose to taxpayers. Both Freddie Mac and Fannie Mae issued the first CRT transactions in 2013 in efforts to convey portions of their previously retained credit risk for the Agency mortgages they guarantee to the private sector. The collateral is newly issued (post-crisis) and incorporates significant reform in origination standards. Further, the reference collateral can vary in coupon and loan-to-value, but is primarily conventional 30 year fixed rate mortgages.

CRT issuance primarily comes in two series: Connecticut Avenue Securities (CAS) by Fannie Mae, and Structured Agency Credit Risk (STACR) by Freddie Mac. As of May 2017, 47 CRT deals with combined security balances of $45 billion have been issued since the program’s inception in 2013. This represents exposure to over $1.3 trillion of residential single-family mortgages. Unlike traditional RMBS securities, payments made to investors are not directly from the underlying mortgage cash flows, but are instead remitted by Fannie or Freddie to CRT investors. The prepayments and the defaults incurred on the underlying reference pools are then reflected in payments by the GSEs to bondholders.

The coupons paid by the GSEs are uncapped LIBOR floaters and carry various attachment points of credit enhancement. The GSE oversight and review of originator and servicer performance provides an additional layer of surveillance, which represents a further positive to underlying fundamentals. The CRT program offers a uniform and standardized investment vehicle for investors to access post-crisis mortgage credit. Program issuance has dwarfed the size of the RMBS 2.0 market (i.e., post-crisis non-QM mortgage securitizations) through today, in part due to the lack of standardization of the RMBS 2.0 market. CRT has become one of the few investment areas where investors can access this post-crisis mortgage credit. The deal structures have been evolving since 2013, initially originating only a first pay (M1) and last cash flow (LCF). Since then, these securities have evolved into anywhere from three to five tranches per transaction collateral pool. The deals now also offer exchangeable securities (MAC) where bondholders can split holdings into various access points of credit tranching or interest rates.

Investors have many options to express views within housing including relative value to other U.S. structured products and broader fixed income, views on the path of home prices and the path of interest rates going forward, and technical factors arising from the declining outstanding float in legacy RMBS sectors. Dealers are heavily involved in making markets on the various tranches due to the synergies in primary issuance and trading this sector in secondary markets. Rating agencies have taken positive actions on many of the tranches due to the credit performance of the assets, issuing several upgrades and positive rating outlooks as the depth of the market continues to grow. Given that the CRT market is one of the only sizable sectors available to investors in post-crisis mortgage credit and underwriting today, the GSEs continue to work on expanding the investor base. For instance, once the work on the products REIT eligibility is finished and implemented, it should further improve the size and depth of the investor base.

The CRT market remains well supported, while the collateral and structural benefits are high. We believe different parts of the capital structure add relative value in our portfolio construction. Some of the areas we find beneficial include:

• Front Cash Flows (M1s) are front sequentials, which pay atop the cash flow waterfall. They shorten as rates rally, but don’t extend significantly in an interest rate selloff. To clarify, mortgage rates are pegged to the on-the-run 10-year U.S. Treasury note and with higher rates, mortgage rates increase, slowing principal prepayments and therefore these bonds slow down or extend. The uncapped LIBOR floater offers additional protection against rising rates enhancing the risk-adjusted return profile. They are low beta and stable carry.
• Last Cash Flows (LCFs) are generally the second or third payer in the sequential waterfall. They are longer in spread duration and carry thick coupon spreads. Similar to the M1, the LCF's are also uncapped floaters that may increase in value in scenarios of higher rates and cash flow extension.
• Modifiable and Combinable (MACs): These options allow a framework for investors to exchange tranches to express differing credit or interest rate views, for example by splitting off the interest-only portion or increasing/decreasing loss support.

Home prices have continued their steady improvement and today, coupled with new post-crisis underwriting guidelines, the underlying sector outlook is strong. Continued enhancements to the program, structure, and the growing depth of the investor base, all while housing and market fundamentals remain robust, are reasons for our focus and positioning within the CRT sectors.