Shrinking Supply Could Be A Boon For CRT Securities

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  • Record issuance of agency CRT securities have hurt prices this year, but rapidly shrinking supply could be a catalyst for near-term outperformance.
  • After a wild ride so far this year, Fannie Mae and Freddie Mac credit risk-transfer securities (CRTs) are looking attractive in the near term.
  • Combined with lower volumes, we believe this tender activity will generate significant CRT tailwinds.

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By Jose A. Pluto

Record issuance of agency CRT securities have hurt prices this year, but rapidly shrinking supply could be a catalyst for near-term outperformance.

As government-sponsored entities, Fannie and Freddie must set aside capital to guarantee the pools of mortgages they package into securities. CRTs provide capital relief by absorbing credit losses on the mortgages the GSEs are insuring.

Record mortgage origination in 2021, combined with Fannie Mae's reinvigorated CRT issuance, looked to boost overall CRT volume to $30 billion to $40 billion this year - more than double the record for annual issuance. Spreads widened as $19 billion of fresh CRTs hit the market in the first half of the year.

Now CRT issuance is slowing as demand for mortgages has declined and the GSEs are choosing to retain the most subordinate CRT bonds. As a result, gross issuance of CRTs for the balance of 2022 will likely cool to around $8 billion.

Better yet, for CRTs, the GSEs' tender activity has ticked up. Since late 2021, Fannie and Freddie have repurchased almost $11 billion outstanding CRT securities.

Here's why: CRT bonds amortize alongside the mortgages they are insuring with the most senior tranches in a CRT receiving principal payments first. That means the GSE's cost of insurance increases over time even as borrowers pay down their mortgages and reduce their leverage. At some point, the cost of that insurance is greater than the capital relief it provides the GSEs. This dynamic becomes more pronounced when house prices appreciate, as they've done for much of the year.

While CRTs contain call options that allow the GSEs to redeem these securities, they tend to have 5-year lockout provisions. Meanwhile, rising prepayments and housing prices are forcing GSEs to act now - hence the expected increase in CRT tenders.

We estimate that an additional $4 billion of CRTs issued pre-Covid could be tendered in the next 3-to-6 months - about 7% of all CRT debt outstanding. The credit enhancement of these securities has increased three- to five-fold since they were issued, and they include underlying loans with an average loan-to-value below 50%.

Combined with lower volumes, we believe this tender activity will generate significant CRT tailwinds.

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