JPMorgan leads 'next little big thing' in mortgage-risk market

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JPMorgan Chase & Co. may be leading the next trend for banks seeking to shift risk away from their mortgage portfolios — if regulators give Wall Street the green light.

The deal last month mimics the credit-risk transfer operations of Fannie Mae and Freddie Mac, using the form of a credit-linked note with payments dependent on those from mortgage loans held on the bank's balance sheet. It offloaded a portion of the credit risk on about $750 million worth of mortgages and could "prove to be the next little big thing" if regulators allow such deals to continue, according to Amherst Pierpont Managing Director Chris Helwig.

The Fannie and Freddie credit risk transfers began in 2013 to reduce taxpayer exposure to their operations. By the end of June they had such transactions on $3.1 trillion worth of mortgages, according to a recent Federal Housing Finance Agency report.

Each transaction was structured into multiple amortizing, sequential-paying, floating-rate securities indexed to 1-month Libor, according to Mark Fontanilla, whose eponymous company created the CRTx Credit Risk Transfer Return Tracking Index. The credit ratings for each security vary depending upon its position within the structure.

Payments and losses are based on the performance of a reference pool of mortgage loans. All classes accrue and pay interest monthly, with principal payments allocated first to the highest priority class (usually designated "M1") and credit losses are applied first to the lowest priority class (typically designated with a "B" prefix).

JPMorgan's private CRT transaction has a similar structure, yet it has a few nuances that make it more "a hybrid of both mortgages and unsecured corporate credit risk," according to Helwig. Both principal and interest payments are unsecured general obligations of the bank itself, opening up investors to counterparty risk. Investors also need to be compensated for liquidity risk because the deal that may turn out to be “little more than a thought experiment” if it fails to get regulatory blessing, he added.

Moreover, JPMorgan is transferring the first 8% of losses, about twice the average seen in Fannie and Freddie CRT deals. The bank is playing it safe in terms of the underlying collateral, so while they are not "qualified mortgages" they are arguably by any measure high-quality loans, with an average size of $775,000, high credit scores, low loan-to-values ratios and about four years of seasoning. Fitch's base case expected pool loss is 0.2%.

Most importantly, the bank reserves the right to collapse the deal if regulatory approval from the Office of the Comptroller of the Currency fails to materialize.

"Depending on how it is structured, banks may find a private CRT attractive for capital relief, better return on capital and improved capital velocity," said Fontanilla. In other words, this could be a way for a bank to sell the credit risk (or at least a portion of it) from a pool of loans, thereby lowering any capital buffer required to be held against it.

So market participants are watching to see whether this deal floats past the regulators or they sink it. Should it pass muster, it could open the door to a new era in mortgage investing.

"For a small deal, it's garnered a lot of attention," said Helwig.

Bloomberg News
Credit risk transfers GSEs Risk management Qualified Mortgages Securitization JPMorgan Chase OCC