Acute losses have been suffered in the US credit risk transfer market over the last few weeks, as prices on many classes of bonds have executed a vertiginous descent. But the price action does not
tell the whole story, and it is too early to say that investors will be cleaned out.
Covid-19 and the virtual cessation of most forms of economic activity throughout the US have rendered assets backed by mortgages particularly vulnerable. A scarcely credible 17 million people have
registered as unemployed in two weeks, and is clear that many homeowners will struggle to meet their mortgage payments.
So, for example, the CAS 2015-C03 M2 bonds - which in February had been happily trading around 109 - went into a rapid nosedive and by 25 March had plummeted to around 82. Since then, there has been
a recovery of sorts and these bonds have climbed back to around 96/97, yielding around 600bp over Treasuries. But this is still a long way off pre-Covid prices.
The newer vintages have been even worse hit. This is because the older bonds have enjoyed four or five years of home price appreciation and have consequently lower LTV ratios. So, over the last seven
days, the average price of M2 bonds is a little over 80, while the B1s are around 55 and the B2s - the lowest rung in the capital stack, with minimum loss protection - are around 10/15.
B1 yields vary from around plus 1500bp to plus 4000bp, say sources. "At the worst level, the B1 2020s were at a dollar price of 14.5 and the B1 2019s were at 11 on 8 April. These are basically
lottery tickets. The market is saying ‘hey, there is virtually little chance you’ll get your money on these.’ Prior to 9 March, these securities were trading at par,” says Joseph Sturtevant,
co-founder and head of valuation at RiskSpan.
Even higher up the capital stack, the recent vintages are sagging on the ropes. The average price of the M2 2020s over the last seven days is around only 60.
But there are technical factors, as well as fundamental at play here. The better protected M1s and M2s have probably sunk in value as much due to liquidity constraints as much as due to expectation
of loss, say sources. Market makers and investors have struggled to finance their positions as, for example, repo markets have seized up. Last week, only just over 50 trades in total were reportedly
As JPMorgan notes in a research paper on the CRT market dated 27 March, the collapse of M2 prices is “more a deleveraging story than a credit fundamental story.”
Moreover, even fundamental assessments of asset value are composed of more than one consideration than the direction of home prices and ability to meet loan payments. There is still uncertainty about
what action the GSEs and the FHA will take towards delinquency and forbearance, and this also drags prices down.
So, the bonds at the bottom of the capital stack - the B1s and the B2s - are probably depressed by the prospects of defaults and foreclosure. They typically possess a credit enhancement of only 25bp
or 50bp, so a foreclosure rate of only 1%-2% would start to erode their value.
But higher up the capital stack, the M1s and the M2s, the constraint upon liquidity is probably the biggest factor. The M1s and M2s are also typically held by more leveraged investors. The JPMorgan
note estimates that hedge funds and REITS make up 50%-60% of new issue demand for M2 paper, and both sets of investors have come under margin call stress lately, producing fire sale prices (SCI 2 April).
Despite the extraordinary dislocation and the prospect of a deep recession, sources in the securitised mortgage markets still seem to think that the M1 and M2 bonds are sufficiently protected.
“Depending on the deal, it will take a loss severity of between 40% and 60% and defaults in the 1%-4% range to hit the 2019 M2s. The M1s and the M2s have a greater probability of loss than they did
before the uncertainty, but we’re probably still not in the expected loss scenario,” says Andrew Davidson, president and founder of Andrew Davidson & Co.
Moreover, the more recent vintages - those priced from mid-2015 onwards - are based on an actual loss structure, so that the investors are only in real danger when foreclosures begin; payment
delinquency does not count as a credit event. The older bonds, from the earliest days of the CRT market, incorporated a so-called fixed severity formula which means they accrue losses with
This difference is reflected in the fact that the CAS and STACR bonds that Moody’s this week placed on review for downgrade are all older vintage fixed severity structures. As it notes in the ratings
rationale: “While a majority of CRT transactions allocate losses based on actual losses to mortgage loans in the reference pool, fixed severity deals will pass losses to investors when investors
become 180 days delinquent.”
The CAS Series 2014-C04, 1M2 and 2M2 - previously upgraded to Aa1 and triple-A on 30 October last year - have been placed on review for downgrade, while four classes of notes from the STACR Series
2014-DN1 - all also upgraded to triple-A on the same date - have been put on review as well. These are all older notes and less than US$650m of outstanding principal is affected.
Nevertheless, the provisions of the recently enacted CARES bill and with the co-operation of the GSEs gives the actual loss deals further room for manoeuvre. Homeowners in financial difficulty can
apply for 180 days of loan forbearance and, upon the expiry of that 180 days, can apply for a further 180 days. The monies are still due at the end of that period, but it gives an entire year before
the possibility of foreclosure enters the picture.
Freddie Mac told SCI it has no plans to alter its CRT issuance for 2020, and it has priced three STACR deals in Q1 with another planned before the end of Q2. Fannie Mae, which priced a US$425m
multifamily CAS deal at the beginning of March, was unavailable for comment.
Investors seem sanguine at the moment. Karlis Ulmanis, a portfolio manager at DuPont Capital, says he is not selling his CRT investments - all of which are investment grade, so above the B1 tranches
- as he is confident that they will bounce back.
Investors also appear sure that the GSEs will not abandon the CRT market when the market returns to normality, whenever that may be. “The CRT sector is very important to the GSEs. I cannot see them
getting rid of the market. They are more likely to offset is as an effective tool to offset risk,” says Ulmanis.
What is likely, however, is that even if a lot of CRT bonds are still standing where the Covid-19 fires become a smoulder, the entire sector may need to be repriced.