Why Wall Street Is Falling in Love with GSE Credit-Risk Transfer Deals

WASHINGTON — The appetite for Fannie Mae and Freddie Mac credit risk transfer deals is growing on Wall Street.

Since the government-sponsored enterprises began experimenting with both frontend and backend deals in which part of the credit risk is shared with third parties, investors have been watching carefully.

"It is one of the most exciting innovations in the mortgage market in my career," said Chris Hentemann, chief investment officer at 400 Capital Management, at an Urban Institute housing finance symposium this week. "And it is constantly evolving…to make it better."

In credit risk deals, investors like 400 Capital pay cash up front and purchase debt securities that are designed to absorb the credit losses on GSE loan pools. Hentemann said his firm has already acquired credit risk on $800 million of GSE mortgages.

Yet there are some who worry whether Fannie and Freddie are trading away profits for little return. In theory, credit-risk transfers are meant to attract private capital into the mortgage market, which remains dominated by the GSEs.

But to entice investors to participate, the GSEs have to lower guarantee fees and backstop any mortgage insurance.

"There are a lot of people who question whether the g-fees the GSEs give up for third-party risk sharing is a fair trade-off for the GSEs and the homeowners they serve," said Scott Olson, a former Democratic staffer to the House Financial Services Committee and an executive director of the Community Home Lenders Association.

The GSEs always provided a guarantee on their mortgage-backed securities while the private mortgage insurers covered a portion of the default risk on the underlying loans. But observers are concerned that third parties aren't willing to take much of the risk.

Olson said it appears you need a 100% government guarantee to attract sufficient investors to MBS. The regulators "have to make the terms of these deals attractive enough to attract private capital into the mortgage market," said Olson, who is also the head of Olson Advocacy Group.

"But there seems to be a consensus that it is important to have private investors in these deals because it provides market discipline," he added.

Hentemann said that the GSEs have effectively "re-engineered their origination processes in a very constructive way."

"We think the originators are aligned with investors," Hentemann said.

But he acknowledged that some investors remain wary, worrying what happens if the market again goes belly up. Without a backstop for the private mortgage insurance, it's unclear what firms would participate in the deals.

"In the high LTV CRT deals, the GSEs have decided to backstop the mortgage insurance component of that piece and that gives us comfort," Hentemann said. "I could say definitively that we would not invest in credit risk transfer deals if the MI recession risk were to fall on us."

Fannie and Freddie have competed $194 billion in high loan-to-value credit risk transfer deals, as of December 2015, according to the latest FHFA data. The loans can have LTV ratios as high as 97%, but most range from 80.1% to 97% LTV.

Overall, Fannie has issued $622 billion in credit risk transfer deals known as Connecticut Avenue Securities and Freddie has issued $589 billion in Structured Agency Credit Risk deals since mid-2013.

Freddie recently revealed its STACR deals reduce its guarantee fee income by approximately 33%.

Meanwhile, the Federal Housing Finance Agency is considering risk sharing deals that could feature deeper mortgage insurance that covers up to 50% of the losses on a pool of loans. Standard MI covers 25% to 35% of loan losses.

John Vibert, managing director and co-head of structured products at Prudential, told the Urban Institute symposium that policymakers seem to have more confidence in private mortgage insurers than investors.

During the housing crisis, the "MI industry failed en masse pretty spectacularly. We think the MIs are the original basket of deplorables," Vibert said. "They were great at collecting premiums but they weren't that good at paying claims."

The U.S. Mortgage Insurers vigorously disagree with such an accusation, arguing that deeper mortgage insurance should be part of a boarder set of credit risk transfers options.

Nearly 97% of all valid claims were paid during the crisis — only "roughly 3% were structured to pay over time," said USMI president and executive director Lindsey Johnson in a statement.

Since the crisis, the remaining mortgage insurance companies have recapitalized and must now meet FHFA financial standards, known as the Private Mortgage Insurer Eligibility Requirements or PMIERs, to insure Fannie and Freddie single-family loans.

"Fortunately some of the riskier mortgage products and practices that led to the financial crisis are no longer available. New regulations have resulted in more stringent underwriting and improved loan data transparency and accuracy," Johnson said.

Hentemann remains optimistic about the CRT market. "It is going through its product cycle and it is being shaped to attract more investors," he said.

The first CRT deal attracted a dozen investors and "now they have hundreds."

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