Most investors are pretty familiar with Fannie Mae and Freddie Mac, the large government mortgage insurers. They guarantee a very large portion of the US mortgage market. They’re basically one of the larger insurance companies out there, but unlike most other insurance companies, they have had no reinsurance.
Hence, several years ago, after the financial crisis where they faced tremendous losses, they took a hard look at how can they shed some of their credit risk.
Enter credit risk–sharing transactions. In a typical agency pass-through mortgage transaction, which is the tried-and-true securities that Fannie and Freddie have issued for decades now, they pull together thousands of different mortgages that they’ll be guaranteeing over a certain period of time, and they issue those to the market, but they guarantee the repayment of principal and interest.
But now, when they issue those securities, they’re also issuing a note called a credit risk transfer security, or CRT, that is tied to that pool of mortgages, but it has some risk of loss to it.
So the CRT securities, they’re usually about four different tranches rated from investment grade to below investment grade or not rated. And with each tranche, as you go down in quality, you get higher yield. But as you go down in quality, you also have some risk of loss. If the mortgage borrowers over here actually default on their mortgages, the lowest-quality tranches in the CRTs may be at the risk of facing losses. And as the losses grow over here, the more that the tranches may face losses.
So there is some risk of loss here. But why we find these CRT securities attractive today is actually many reasons. One, the fundamentals in the US real estate market are very strong. If you think about what’s happening in housing today, the real estate market remains solid because borrowers remain solid. The job market is strong, household net worth has been on the rise. So you’re looking at a pretty strong fundamental picture, and losses have actually been coming in even less than we’ve expected.
You combine that with the nature of the CRTs: they’re actually floating rate. They trade off of one-month LIBOR. So you’re spread to one-month LIBOR. In an environment of rising rates, that’s very appealing, to tap into that floating-rate higher yield.
And finally, we have to keep in mind, these are conforming mortgages. So getting back to the fundamental idea, these are borrowers that have good FICO scores, that actually have good loan-to-value ratios. They have conformed to the Fannie and Freddie standards. This is not harkening back to 2006 and ’07, where we had borrowers with no incomes, no jobs, no paperwork to support.
In an environment of low and potentially rising yields, investors are on the hunt for any kind of income that they can get, and as many diverse sources of income as they can find. CRTs really answer that search. They provide you with a different fundamental story that’s tied to the real estate market—not, say, corporates or emerging markets. And they provide you with floating-rate income which is appealing as rates may tend to move upwards.
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.