Opportunity in Agency Credit Risk Transfer Bonds
by Semper Capital, on Jan 31, 2022
Fannie Mae’s and Freddie Mac’s Credit Risk Transfer bonds (CRT) offer investors the ability to access scalable mortgage credit and housing market exposure while eliminating interest rate risk and benefitting from the structural advantages of investing in bonds supported by fully amortizing loans.
We believe there is an immediate opportunity within the mezzanine and subordinated tranches of these CRT bonds. Both B1 and B2 profiles should perform very well against the backdrop of 2022, supported by the rapid accumulation of home equity through home price appreciation (HPA) and structural de-levering of these bonds, the result of rapid mortgage refinancing activity.
The opportunity is based on:
- Strong fundamental housing market provide great credit underpinning of the assets
- Expectations for continued home price appreciation with supporting technical characteristics
- Structural characteristics of the bonds provide positive exposure and performance in a rising rate environment
- Limited supply and structural complexity provide additional return potential through increased coupon and price appreciation
Agency Credit Risk Transfer Outlook:
Ideally positioned for 2022’s rising rates and continued inflation expectations.
Fannie Mae’s and Freddie Mac’s Credit Risk Transfer bonds (CRT), issued on their CAS and STACR shelves, offer investors the ability to access scalable mortgage credit and housing market exposure at various levels of the capital stack, while eliminating interest rate risk and benefitting from the structural advantages of investing in bonds supported by fully amortizing loans.
Mezzanine/subordinated CRT bonds, both B1 and B2 profiles, should perform very well against the backdrop of 2022, supported by the rapid accumulation of home equity through HPA and structural de-levering of these bonds, the result of rapid mortgage refinancing activity:
- Housing fundamentals are strong by way of tight underwriting standards, strong consumer balance sheets, demographic trends creating an ongoing housing shortage, and robust forecasted HPA for the next several years in the aftermath of record ~20% HPA over the last year. This housing market strength is a further tailwind to the de-levering of existing CRT structures from rapid prepayments, few delinquencies, and minimal expected principal losses.
- Over the last 7 quarters home prices have risen 28% nationally. This is equivalent to about 7 years of historical trend line HPA. This imbedded home price appreciation is a significant credit positive for RMBS securities today as it has created a meaningful equity cushion that strengthens borrower’s credit position and protects against any potential losses from housing turnover.
- Today’s general price inflation from supply chain disruptions and the reopening of the economy, can fundamentally become a drag on corporate earnings and profits. However, sectors backed by residential assets, including CRT, this is a credit positive as borrowers experience wage growth and home prices – historically a strong inflation hedge - continue to increase.
- Higher Inflation has led expectations for rising interest rates in 2022 and a curtailment of accommodative monetary policy. For CRT this provides the dual benefit of increased carry, as the sector’s floating rate coupons reset higher, and slowing prepayments on the underlying mortgages, which will lengthen average lives of premium dollar priced mezzanine securities issued post COVID.
- The technical story in the CRT market is also positive as seasoned profiles will become more scarce through a combination of pay downs - $9 billion expected in 2022 - and Government Sponsored Enterprises (GSE) tender offers, while opportunities to replace these profiles in the primary market will be reduced due to structural changes that make new CRT bonds less investor friendly.
- Seasoned B1 bonds currently have carry in a range of 4-6%. Given the structural and housing backdrops we believe these bonds could realize 2 to more than 4 points of price upside in 2022 in rising rate scenarios, with additional upside to potential rating agency action.
- Seasoned CRT B2 bonds, although mostly unrated, will continue to benefit from the de-levering through prepays and HPA as loss coverage multiples become even more robust, while structural changes in the primary market will enhance the scarcity value of these profiles. We believe that these bonds, with coupons in the 5%-10+% context can have more than 5 points of price upside from their gradual credit curve roll down, with additional price upside possible should interest rates continue their path higher and prepayment speeds slow further.
CRT bonds were first issued in 2013, as a way for the GSEs to transfer risk on a portion of their mortgage market guarantees to the private market. Since inception the GSEs have transferred over $100 billion in credit risk with $45 billion of bonds currently outstanding. Each CRT transaction, typically a 1bn in total bond size, references large, geographically diverse, collateral pools in the hundreds of billions. The program has been successful in transferring the potential for losses from mortgages away from the GSEs while offering very strong overall returns for investors over the sector’s life. Last year the former director of the FHFA published a white paper lamenting the cost of the program to the GSEs and the negligible losses that have been passed on to investors – a negative for the issuers but a strong positive for investors. The market has seen significant changes over the last several months, including Fannie Mae’s delayed return to the market following the pandemic, the first tender offers by Fannie and Freddie, and structural changes to the most recent CRT transactions making seasoned bonds even more attractive in comparison.
Our 2022 outlook for the CRT sector is very positive for several reasons:
- Forbearance Programs, begun by the GSEs and servicers at the outset of the pandemic, are winding down with 85% - 90% of loans that entered into a forbearance program having cured, prepaid or been modified thus far. The relatively small population of loans that will remain delinquent after the programs end have built HPA of 20-30% or more since the pandemic started, making home sales more likely than foreclosure in our view. Loans that do liquidate are expected to do so with minimal loss due to the high percentage of embedded home equity today.
- HPA is expected to stay elevated into 2023 (2022 7-12%; 2023 5+%) according to sell side research projections. The continued supply/demand imbalance in housing is expected to persist into the coming years. This means that both new collateral and seasoned collateral will continue to build home equity. By the end of 2022 modestly seasoned CRT profiles (from 2018-2020 vintages) are projected to build 40-50%+ of total home equity, as a result these bonds remain highly attractive, especially at current spread levels, versus their underlying current and projected fundamentals. Below is an example of how an example 30-year fixed rate mortgage loan, like those in Credit Risk Transfer securities, de-levers with HPA:
Source: Semper, Morgan Stanley, BAML, Nomura
- The mortgage underwriting for loans in today’s CRT deals remains close to the post great financial crisis tights, increasing the bonds’ credit quality significantly. The most recent, on the run collateral originated post pandemic offers strong relative value, with post pandemic deals benefitting from 1+ year of structural de-leveraging and double digit HPA. These deals also had some of the highest quality collateral pools as a result of the pandemic. The majority of borrowers that ended up in these reference pools remained current throughout the pandemic and were able to refinance into lower rate mortgages as a result. The subordinated bonds in these vintages therefore offer access to some of the strongest fundamentals along with relatively high carry and further price upside to rolldown and potential credit rating agency upgrades.
- Elevated prepayments over the last few years have significantly de-levered CRT structures. Upgrades were gradual in 2021, but we expect upgrade activity will accelerate given the buildup in HPA, the structural de-leveraging, increasing loss coverage ratios on the bonds, and removal of rating agency pandemic model overlays.
The example below shows how the STACR 2020-DNA4 has de-levered since issuance in Q3 2020:
Source: Semper, Bloomberg
- CRT bonds have floating rate coupons, ideal for a rising rate environment. CRT coupons will reset higher as the Fed raises their target Fed Funds rate, increasing carry. Higher coupon CRT bonds, exhibiting negative effective duration, will outperform further as prepayments slow from rising interest rates, extending average lives and increasing the present value of these cash flows – leading to potential price increases. Unlike many legacy RMBS structures, there is no risk of interest shortfalls because these floating coupons are obligations of the GSEs.
Overall, the outlook for the Credit Risk Transfer market is positive for 2022 given:
- Access to floating rate, and negative duration paper at attractive spread levels
- Continued strength and outlook for housing in conjunction with the high credit quality and de-levering of existing structures
- Expected acceleration in rating agency upgrades due to the structural de-levering and imbedded HPA in many existing the deals today
In our view, the best way to express these views is through the B1 and B2 subordinated classes of deals issued prior to late 2021, which we believe have already become relatively more attractive than new issues and stand to benefit most directly from the dynamics described above.
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