US Housing Reform and the Future of Credit Risk Transfer (CRTs) securities

by Michael Canter, Director, Multi-Sector and Securitized Assets, AllianceBernstein

Credit risk-transfer securities (CRTs) have made the US mortgage market safer by shifting default risk from taxpayers to private investors. The latest attempt to overhaul the housing finance system isn’t likely to change that.

A recent memo from President Donald Trump directed the US Treasury to come up with a plan that would end government control of Fannie Mae and Freddie Mac, and possibly return them to private hands over the next few years. The government took over the companies after they suffered massive losses in 2008.

At this point, the memo is just a plan to make a plan. Even so, it has some investors worried that privatization could end the government guarantee of coupon and principal payment that the bonds issued by Fannie and Freddie carry. That would depress prices of existing mortgage-backed securities and likely hurt market liquidity. Some also worry that it might put the future of the CRT market in doubt.

We don’t think that’s likely. CRTs are already doing one of the things that the reformers in the White House and Congress say they want done: insulating taxpayers from losses.

Sharing Risk, Reaping Rewards

Fannie and Freddie began issuing CRTs in 2013. Like typical agency bonds, CRTs pool thousands of different mortgages into a single security, and investors receive regular payments based on the performance of the underlying loans. But there’s a key difference: CRTs carry no government guarantee of principal and coupon payments. If a large number of the loans default, private investors in these securities would be first to absorb losses.

By building a layer of private capital into Fannie and Freddie’s capital structure, these securities have been successful in shoring up the market and getting US taxpayers off the hook for losses. They’ve also been popular with investors because they offer relatively high yields and floating interest rates, which offer protection in rising-rate environments.

Of the roughly $5.5 trillion of mortgage-backed securities guaranteed by the government-sponsored enterprises (GSEs), as Fannie and Freddie are known, about $1.4 trillion have CRTs tied to them. As existing mortgages are refinanced or retired, we expect this amount to rise, as more risk is transferred from the GSEs to the private sector.

Would these trends change if the GSEs are eventually freed from government control? We doubt it. Releasing the GSEs from conservatorship means they would have to be properly capitalized first. That’s a process that would take years, not months, and CRTs would almost certainly play a major role in building up the companies’ private capital.

The Case for Government Involvement in Housing

We’re also not convinced that the government will exit the mortgage market altogether. Housing is crucially important to the health of the US economy, and it’s hard to imagine the government looking the other way during a crisis. While we support shrinking the government’s role in housing finance, we are against eliminating it.

What’s more, agency mortgage-backed securities issued by Fannie and Freddie make up one of the largest and most liquid fixed-income markets in the world. Global investors provide more than $5 trillion in mortgage financing, which helps to keep credit available and allows borrowers to lock in rates when they purchase or refinance a home. If government involvement were removed, many of these buyers would likely disappear. That would be highly disruptive to the housing market and would almost certainly reduce home sales and home prices.

Even a privately owned Fannie or Freddie would likely be subject to government regulation, and its securities would likely carry some type of guarantee. In this system, CRTs would remain an important way to spread risk to private investors to provide a capital cushion that protects taxpayers before a government guarantee kicks in. What’s more, we think there’s broad support for CRTs in Congress on both sides of the aisle.

Reform Won’t Happen Overnight

While the Administration has many reform alternatives to choose from, we think it will ultimately do what the market expects and preserve the parts of the current system that work. That means working with Congress to extend an explicit government guarantee on agency mortgage-backed securities (MBS).

This will help preserve the 30-year fixed-rate mortgage—the go-to form of financing for most borrowers and the backbone of the US mortgage market—and the to-be-announced, or TBA, market that makes it possible for investors to bid on MBS without knowing which loans they contain. It’s not clear that either would survive without a government guarantee, as investors may balk at assuming the duration and default risk.

In an interview with Bloomberg late last year, US Treasury Secretary Steven Mnuchin said, “My overall view is, on the one hand, I want to make sure there’s access to liquidity and capital for consumers. On the other hand, I want to make sure whatever we do in restructuring [the GSEs], we don’t put the taxpayer at risk.”

We couldn’t agree more, and we think a system that builds in a significant private capital cushion before a government guarantee kicks in accomplishes both goals.

Michael S. Canter is Director of US Multi-Sector and Securitized Assets, and Janaki Rao is Portfolio Manager and Head of Agency Mortgage-Backed Securities Research at AllianceBernstein.

The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AB portfolio-management teams and are subject to revision over time.

This post was first published at the AllianceBernstein blog

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