New credit deals introduce sources of risk into bond funds.
By Brian Moriarty
Created in 2013, credit risk transfer, or CRT, deals issued by Fannie Mae and Freddie Mac are designed to move mortgage credit risk from the agencies’ balance sheets to private investors. Gross issuance has exploded since 2013’s first deal, reaching a cumulative total $48 billion as of August. The programs are required by a mandate from the Federal Housing Finance Agency, which is still the conservator for both Fannie Mae and Freddie Mac. There are a couple of twists, but FHFA’s mandate states that the agencies should target at least 90% of new single-family agency mortgages’ principal for risk transfer.
Asset managers and hedge funds have been drawn to CRTs by attractive yields, as well as back-testing that suggests they would have held up well during the financial crisis. They have also been gobbled up by investors hunting a replacement for legacy nonagency residential mortgages—which have been strong performers since bottoming out during the financial crisis— as that sector has been steadily shrinking.
Notably, CRTs don’t represent ownership of actual mortgage pools. Rather, the securities’ cash flows are structured so that they reference the activity of specific pools of mortgages held by Fannie and Freddie. Thus, CRT deals are akin to credit-linked notes. The agencies use mortgage pools on their balance sheets as a reference (that is, reference pools), and sell tranches of securities with different risk profiles whose cash flows are based on activity in the reference pools. Those cash flows are paid by Fannie and Freddie (rather than directly from the mortgage pools), but the agencies are only obliged to pay investors based on the promises of each individual security. If the underlying mortgage pools experience defaults, CRT investors will bear the brunt of those losses. In other words, CRTs are completely different from traditional agencybacked mortgages.
CRTs are typically split into senior, mezzanine (usually rated BBB or BB), and subordinate tranches (usually rated B or not rated). They have floating coupons, usually one-month Libor plus a spread. The structure is effectively a stack of synthetic tranches based on the reference pools, but the agencies only sell the mezzanine and subordinate tranches of each stack. In fact, the senior pieces don’t actually exist as securities. Whatever risk or benefit would theoretically accrue to them is effectively borne—or retained— by the agency offering the deal. Unlike non-agency mortgage tranches (which are paid off sequentially), CRT tranches are paid off pro-rata at the same time as long as defaults in the reference pool don’t get too large. If mortgages begin to fail and subordination falls below a target, though, principal payments are diverted away from—and the impact of losses is thus felt by— investors holding the CRT tranches.
CRTs look a lot like other collateralized mortgage obligations, but they’ve been distinguished by how “thin” the tranches are that are being sold to investors. For most securitizations with credit risk, the biggest appetite is for the senior tranches, which carry the most credit enhancement, but the agencies are selling only mid- and lower-level CRT tranches to investors. And because senior tranches typically compose the lion’s share of a deal— 95% in the case of one 2014 CRT deal—even the middle-tier tranches being sold to investors are low in the structure, and very thin. The “safest” middle-tier tranches, for example, have very little capital underneath them (that is, credit enhancement) to absorb losses. In a severe housing crisis, the securities could very quickly go from hero to zero.
Another concern is that some investors may infer a false sense of security with CRTs. Because the interest payments are coming from Fannie and Freddie, and not directly from the reference pool of mortgages, some firms have technically classified them as “agency” securities, despite their inherent credit risk. What’s more, despite the sector’s explosive growth, the volume of CRT bonds outstanding (roughly somewhere between $30 billion and $40 billion) is still a drop in the bucket compared with other fixed-income sectors, and a liquidity crunch is certainly possible.
There’s another risk factor that could become more important in the future. It’s in the agencies’ best interests to transfer as much risk as possible into CRT deals. The more credit risk they can shed, the better it is for their own balance sheets and for taxpayers. To the degree that the agencies can choose which mortgages to insert into CRT pools, their interests diverge from those of CRT investors.