Morningstar Magazine - October/November 2017 - 64

Strategies

Fannie and Freddie's Risk Transfers
New credit deals introduce sources of risk
into bond funds.

INVESTMENT RESEARCH: CREDIT

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

64

Morningstar October/November 2017

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.
Concerns
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.
Verdict Is Still Out
CRT deals are designed to be beneficial to

Fannie, Freddie, and taxpayers. The verdict is still
out on whether they will also prove to be
good for investors over the long haul. CRTs have
been among the strongest fixed-income performers
since their creation, and the first reference
pools were relatively high quality. However, we
have begun to see lower-quality mortgages and
higher loan/value ratios in recent deals.
CRTs are appearing in more bond funds, particularly in the intermediate-term and multisector
bond categories, mostly in small amounts.
(Today's CRTs show up in portfolios as "CAS" from
Fannie or "STACR" from Freddie.) It makes
sense to keep an eye on exposure to this new
source of risk and return. K
Brian Moriarty is an analyst covering fixed-income
strategies with Morningstar Research Services.



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