Download What are GSE Credit Risk Transfer securities?

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What are GSE Credit Risk Transfer securities?
Credit Risk Transfer (CRT) securities are general obligations of the US Federal National Mortgage
Association, commonly known as Fannie Mae, and the US Federal Home Loan Mortgage Corporation,
commonly known as Freddie Mac. These Government Sponsored Enterprises (GSEs) are mandated
to expand the secondary market for residential mortgage loans through securitization. Fannie Mae
and Freddie Mac purchase and securitize loans and sell the resulting mortgage-backed securities
(Agency MBS) in the secondary market. Agency MBS are guaranteed by the GSEs, meaning that
these entities are responsible for the timely payment of principal and interest on the bonds and bear
the risk of credit losses on the underlying loans.
CRT securities were created in 2013 to effectively transfer a portion of the risk associated with credit
losses within pools of conventional residential mortgage loans from the GSEs to the private sector.
Unlike Agency MBS, full repayment of the original principal balance of the CRT securities is not
guaranteed by the GSEs; rather, “credit risk transfer” is achieved by writing down the outstanding
principal balance of the CRT securities if credit losses on the related loans exceed certain thresholds.
By reducing the amount that they are obligated to repay to holders of CRT securities, Fannie Mae
and Freddie Mac are able to offset credit losses on the related loans.
Background
The CRT market is a product of the efforts of Fannie and Freddie’s regulator, the Federal Housing
Finance Agency, to accelerate the return of private capital to the residential mortgage loan market
following the financial crisis. As home prices started to decline in 2007 and the US subsequently
entered a recession, defaults on guaranteed loans escalated dramatically and the GSEs suffered
significant losses. In September 2008, the GSEs were placed under the conservatorship of the US
Treasury and received financial support in the form of lines of credit — effectively a bailout funded
by US taxpayers. The credit risk transfer initiative seeks to reduce the exposure of taxpayers to such
an event in the future by placing the GSEs in a last loss position rather than a first loss position with
respect to most of the loans that they guarantee.
Growth
The CRT market has grown rapidly since its debut in July of 2013. Investor reception has been
robust as it has become increasingly difficult to source exposure to credit risk linked to the residential
mortgage loan market. As of August 2016, the GSEs had issued USD 34.6 billion CRT securities.1
These transactions have provided the GSEs with credit loss protection on over USD 1.1 trillion of
loans to date.1
Today
CRT securities have come to represent the predominant form of non-guaranteed debt issuance related to
recently originated residential mortgage loans in the US. They have enabled a wide range of investors to
gain credit exposure to the ongoing recovery of the residential real estate market. We expect total issuance
in 2016 of approximately USD14 billion, compared with USD12.6 billion in 2015.2
Why consider CRTs?
CRT securities can help diversify the risk profile of a fixed income strategy by providing credit
exposure to the US residential mortgage market. We believe this sector offers a potentially
compelling opportunity due to the strength of US residential real estate fundamentals and the high
quality of loans that Fannie and Freddie have acquired in recent years. Additionally, floating rate
LIBOR-based coupons could help to mitigate uncertainty related to the future path of interest rates
and allow investors to benefit from increases in LIBOR that have resulted from regulatory reforms.
This document is for Qualified Investors in Switzerland, Professional Clients in Continental Europe, Dubai, Guernsey, the Isle
of Man, Jersey and the UK; for Institutional Investors only in the United States and Australia; for Professional Investors in
Hong Kong; for Qualified Institutional Investors in Japan; for Persons who are not members of the public (as defined in the
Securities Act) in New Zealand; in Singapore for Institutional Investors and/or Accredited Investors; in Canada, this document
is restricted to Accredited Investors as defined under National Instrument 45-106. It is not intended for and should not be
distributed to, or relied upon by, the public or retail investors. Please do not redistribute this document.
The loans underlying CRT have performed well in recent years as home prices increased and the
labor market improved. In contrast to many other asset classes, we believe that tight supply and low
mortgage rates will continue to drive sustainable home price gains. Rating agencies have recently
been active in upgrading CRT securities, and we expect this cycle to persist. Looking forward, we
believe an expanding investor base is likely to improve liquidity in the CRT market, and relative credit
risk premiums may contract as the sector continues to mature.
How IFI is different3
Invesco Fixed Income (IFI) employs a balanced top-down, bottom-up approach in our portfolio
construction process. Our top-down analysis examines factors in the broader economy such as
GDP growth, interest rates, labor market dynamics, consumer data and corporate earnings. Our
analysis then defines fundamental trends in residential real estate such as housing stock, mortgage
originations, delinquency rates, loan origination conditions and housing performance across distinct
geographical areas, which, in turn, shape our outlook for the residential market and the performance
of housing-related debt. Robust bottom-up credit analysis also plays an important role.
For any potential investment, our analysis begins at the loan level. Key collateral and borrower
characteristics including delinquency status, loan type, balance, geographic location, property
type, documentation type, occupancy status, current loan-to-value ratio and credit scores are
reviewed to determine appropriate assumptions for prepayment and default expectations. Property
level assessments and geographically detailed home price indices are utilized to update collateral
value estimates. Where appropriate for the type of security, the team formulates assumptions for
variables that are influenced by transaction parties, such as the servicers that collect payments from
borrowers and manage property liquidations. Once base case assumptions have been established,
we perform structural analysis under multiple scenarios to determine likely cash flow profiles and
to quantify the amount of projected loan loss relative to the credit protection provided by the
transaction structure.
How CRTs work
Each CRT transaction generally includes several tranches that cover a range of cash flows, credit
risk and potential return profiles. Historically, tranches with the highest credit quality have been
rated A and feature a relatively short expected cash flow window and a large amount of credit
protection in the form of a higher level of subordination. BBB rated tranches feature longer
expected cash flow windows and lower levels of subordination. Finally, below investment grade
tranches represent the longest expected cash flows and have the least credit protection, but
typically offer the highest potential returns. Tranche prepayments and write-downs are based
on the performance of the reference mortgage loan pool. As loans are prepaid, the most senior
tranche is first in line to receive the proceeds, followed by lower-rated tranches as outstanding
balances are paid off. As defaults occur, losses are allocated sequentially from the tranches with the
lowest rating to the highest. Thus, below investment grade tranches experience write-downs first,
and if they are written down entirely, BBB rated tranches begin to take write downs, and so on.
Typical CRT Transaction Structure
Last
Loss
Senior risk retained by GSEs
Reference mortgage
loan pool
Lower
Credit
Risk
Highest rated CRT classes
(mezzanine risk)
Lowest rated/non-rated CRT classes
(subordinate risk)
1 Derived using Intex data, 31 Aug. 2016.
2 Derived using Intex data, 31 Dec. 2015.
3 Invesco Fixed Income (IFI) is a unit comprising Invesco Advisers, Inc. of Atlanta, Georgia;
Invesco Asset Management Limited, of London, U.K.; and Invesco Canada Ltd. of Canada.
First
Loss
Higher
Credit
Risk
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