FHFA capital changes could boost credit risk transfer issuance

The Federal Housing Finance Agency’s reevaluation of the government-sponsored enterprises’ capital rules should increase usage of credit risk transfers, observers said.

Fannie Mae has not made any new CRT deals since March 2020, while Freddie Mac’s pace of issuance has been slower than in years past. Both agencies were reacting, in part, to former FHFA Director Mark Calabria’s revision of the GSEs’ framework, which required them to hold more funds for these deals.

Through the end of last year, Fannie Mae and Freddie Mac have transferred a portion of credit risk on $4.1 trillion on mortgages with an unpaid principal balance. These have combined risk in force of about $137 billion, according to an FHFA report released in August. That includes securities issuances, insurance/reinsurance transactions, senior-subordinate securitizations, and a variety of lender risk-sharing transactions.

Last year, Freddie Mac’s CRT deals totaled $484 billion UPB, its most since this asset class was introduced in 2013. In the first half of this year, it did $419 billion.

But for 2020, Fannie Mae did only $164 billion, its second lowest ever; only in 2013 did it do fewer transactions, at $32 billion.

“Some reversal of [Calabria’s capital rule] could be a source of new supply of CRT for sure, bring Fannie Mae back into the market, and make it economically more advantageous to do CRT in the first place for both enterprises,” said BTIG analyst Eric Hagen.

Fannie Mae did stop its issuances just around the start of the pandemic, but the securitization market has changed dramatically since then.

“Part of the reduction in risk transfer is due to the significant widening in credit spreads for CRT and unguaranteed tranches since the onset of the COVID-19 pandemic last year,” said a report from Barclays’ analysts Anuj Jain and Pratham Saxen. “However, spreads have now normalized, but the pace of risk transfer from the GSEs remains slow, driven to some extent by the capital rules that went into effect earlier this year.”

Furthermore, for mortgage-backed securities investors, CRT deals are a means by which investors can benchmark and assess the costs of capitalizing mortgage credit risk, Hagen said.

So, “ramping issuance would be a welcome development for yield-hungry credit investors, while creating perhaps the strongest backdrop for lenders that had been (prior to last March) sharing risk with the GSEs on their own originations, such as PennyMac,” he noted, a sentiment that the Barclays’ analysts agree with.

“We think that these proposed changes, if implemented, should lead to increased risk transfer from the GSEs, especially in a low-yield environment where demand for spread is very high,” the Barclays report said.

The changes would increase the capital incentives for the GSEs doing CRT transactions, Keefe, Bruyette & Woods analyst Bose George said in a report.

“While the impact on risk-based capital could vary, based on GSE disclosures, we believe that minimum risk-based capital is also likely to decline by around 25%, which suggests that risk-based capital could also be around 3%,” he wrote.

Freddie Mac did not comment on the proposed changes. However, in its formal comments on the Calabria proposal that was finalized last November, the company said, “Our recommendations would incentivize the purchase of additional protection rather than decrease the use of CRT. The 10% floor should be replaced with a 25% increase in the detachment level necessary to achieve full stress-scenario loss protection.”

Freddie Mac had also called for the 10% haircut on third-party tranches to be replaced with a modified process for applying an overall effectiveness adjustment, but only to certain CRT transactions that may have higher idiosyncratic or complexity risks than existing structures or deal sizes in use by Freddie Mac.

They are apparently in line with the FHFA’s revised proposal, which would replace the prudential floor of 10% on the risk weight assigned to any retained CRT exposure with a 5% floor and remove the requirement that Freddie Mac and Fannie Mae must apply an overall effectiveness adjustment to its retained CRT exposures.

Fannie Mae’s comment letter to the Calabria proposal proposed something similar; “To better tailor the treatment of CRT to the specific risks identified, Fannie Mae recommends eliminating the 10% minimum risk weight on retained CRT tranches and, for single-family CRT, increasing the overall effectiveness adjustment,” the agency stated. The letter argued that its own recommendation addressed “the concern that covered loans may refinance out of a pool when new CRT coverage is unavailable.”

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