Credit risk transfers are key to GSEs’ exit strategy

But moves by FHFA Director Calabria and a possible Supreme Court ruling cloud the market's future

Washington D.C

We all know the story. Amidst a widespread and imprudent weakening of credit standards and a complete failure by the credit rating agencies to properly assess risk, the housing finance market imploded in 2008. Probably the biggest wipeout was in the then privately owned mortgage securitizers, the GSEs, where every one of their mortgage-backed securities carried an implicit federal guarantee.

Fast forward to 2020 and a lot has changed at the government sponsored enterprises. About $7 trillion of MBSs that the two have underwritten and that are outstanding still carry the government’s guarantee stamp, which creates huge savings for homeowners whose mortgages qualify for inclusion in GSE securitized MBS pools.

But the credit guarantee is more explicit now than implicit because the GSEs are no longer privately owned, but instead are effectively owned by the federal government through a conservatorship arrangement overseen by the Federal Housing Finance Agency, created in 2008.

Post-2008, a few politicians, perhaps the U.S. Treasury, some regulators and very few people at Freddie or Fannie like the conservatorship arrangement. Simply removing the federal guarantee stamp hasn’t proven possible politically – neither side of the aisle wants irate voters whose mortgage costs have skyrocketed. But pretty much no one likes the nearly $7 trillion of taxpayer funded credit risk assumption either.

Enter credit risk transfers. First issued by Freddie Mac in 2013 and followed quickly by Fannie Mae, CRTs do exactly what they say they do: they transfer credit risk away from the GSEs, and the federal government, to the private sector purchasers of CRTs who are, of course, compensated for taking on GSE MBS credit risk.

The GSE MBS CRT revolves around what is a tiered loan loss exposure. In a typical CRT, investors are offered four ways to participate, or four tranches of loan loss, with the last tier taking on the expected losses, and thus taking on the highest risk, and the top tier taking the last of the loan loss and thus being the safest tranche.

CRTs typically cover about four percentage points of the loan loss, with any credit risk above that kept by the GSEs. And GSEs also typically retain the riskiest CRT tranche on their books, known as the expected risk in the CRT, selling to investors only the other less risky tranches, the unexpected risk.  

And there are often other credit protections that kick in before the CRT, like mortgage insurance, that further protect GSE MBSs against loan loss.

“Today’s GSE MBS pools are much, much higher in credit quality than in the years preceding the 2008 housing crisis,” says Chris Helwig, single-family home finance expert and managing director of structured product strategy at New York-based Amherst Pierpont Securities.

He pointed out that the typical mortgage in a GSE MBS pool today is basically very conservatively underwritten and adheres more closely to the 20% down payments that were typically required before credit standards fell apart in the years preceding 2008.

Helwig emphasizes that the current threshold of four percentage points of loss, much of which is taken on by CRT investors, must be seen in the context of the tighter mortgage underwriting standards now prevailing, extra credit protection like mortgage insurance, and the very strong performance of house prices in recent years.

And mortgage credit has been performing very well. The expected loan loss tranche of CRTs, which the GSEs retain, covers roughly the first 25 to 50 basis points of credit loss depending on the CRT, but actual experienced losses pre-COVID didn’t move much beyond about 10 basis points, says John Kerschner, who started the securitized mortgage division at money manager Janus 10 years ago.

Post-COVID, though, there is great uncertainty with regard to forbearance issues and whether or not the damaged economy will ultimately lead to significant loan loss. The rate at which people are still paying down mortgages despite forbearance is much higher than expected, but continued good post-COVID performance may be dependent on more stimulus from Congress.   

“Investors have participated in CRTs because as currently structured they are outstanding fixed income investments that adequately compensate risk and provide a novel way to play a specific aspect, credit, of the single family mortgage market , which in the past was very difficult for fixed income investors to access,” Kerschner says

Some recent news articles on CRTs have implied that at about $50 billion in outstandings, CRTs provide little credit protection relative to the $7 trillion or so of Freddie and Fannie MBSs in force. Helwig says, though, that CRTs have indeed had substantial success in their core mission of transferring credit risk away from taxpayers and the GSEs.

Kerschner agrees: “About 40% to 50% of the total credit risk in those eligible among the nearly $7 trillion of Fannie Mae and Freddie Mac MBSs outstanding has been transferred to the private sector.”

Kerschner also says that CRTs play a crucial role in efficient price discovery, providing a market-based insight into the price of mortgage credit risk generally. That was something that was sorely needed in the crisis of 2008 and will help increase accuracy in a whole host of calculations, not the least of which is the proper level of capital to set aside to back mortgage portfolios.

Freddie and Fannie have succeeded in attracting the right investors to the CRT market. There are hundreds of major institutional investors, domestic and international, who have devoted considerable resources to becoming regular and supportive CRT market participants. And, needless to say, the CRT initiative for Freddie and Fannie has arguably been the most important, and expensive, for the two GSEs since 2008.

In fact, CRTs have been central to the Holy Grail of Freddie’s and Fannie’s strategy of getting out of conservatorship, back completely in private hands with a capital structure that minimizes reliance on taxpayer-backed MBS credit protection.

But there are some that like things just the way they are. In 2008, the $189 billion the federal government spent bailing out Fannie and Freddie seemed like a disaster for the taxpayer. It has, instead, turned into a gold mine.

Not only was the $189 billion paid back in short form, but an additional $109 billion has been paid. And lately, annual negotiations between the FHFA and the Treasury have been dispensed with, the Treasury now automatically “sweeping” Fannie and Freddie books and depositing the proceeds.

The sweep is an arrangement that has enraged the holders of the small slice of equity allocated to Fannie and Freddie investors post 2008. In the aggregate, that small slice could have considerable value now, but not when the fruits of Fannie’s and Freddie’s labors are appropriated by the Treasury every year.    

While the GSEs have been counting on CRTs big time – the reason they both devoted huge resources to the market’s creation – to help move them out of conservatorship, a wrench has been thrown into those plans by Mark Calabria, the Trump-appointed FHFA director.

Early this year, Calabria proposed that the amount of capital relief provided by CRTs be roughly cut in half from levels proposed in 2018, stunning Fannie and Freddie. Freddie just in the third quarter started issuing CRTs again and Fannie has issued no CRTs since Calabria’s proposals.

Calabria backtracked somewhat on CRTs in the FHFA’s Final Capital Rule, published in late November, which significantly increased overall proposed capital levels for the GSEs post conservatorship. However, the CRT capital relief in the Final Capital Rule is still a far cry from levels proposed in 2018, say both Helwig and Kerschner.

According to Kerschner, the gap in CRT issuance following Calabria’s proposal early this year reflects more of a protest by the GSEs that they won’t issue CRTs that are uneconomic, which the GSEs say would be the case if Calabria’s proposal were adopted. The trading market for CRTs, and demand for them, has been little affected with participants taking a wait and see attitude about how things will play out, he says.

And the Calabria problem won’t immediately be solved by a change in administration, because Calabria’s term is for five years and, once appointed, legislation directs that the president cannot interrupt that term by bringing in a new appointee.

The legislation is similar to that which created the Consumer Financial Protection Bureau in 2011. In June, the Supreme Court ruled that the CFPB’s structure was unconstitutional, and the current CFPB Director, Kathy Kraninger, is widely expected to be replaced when president-elect Joe Biden takes office.

This week the Supreme Court heard arguments on the constitutionality of the FHFA’s structure and whether that would affect the Treasury’s sweep of Fannie and Freddie’s profits.

The Court is expected to rule on the FHFA case in June. If it finds the five-year term is unconstitutional, Calabria will be replaced and there will be a good chance that his CRT capital proposal will go with him. It is unclear, however, what, if any, stance the Biden camp has formed on CRTs.

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