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Capital trouble

GSEs stare down the barrel of reduced capital relief for CRT deals

The re-proposed capital rules for the GSEs before they exit conservatorship, released by the Federal Housing Finance Authority (FHFA) on May 20, add further doubts to the future of the credit risk transfer market, according to market opinion.

Compared to the rules released in 2018, the new iteration cuts in half the credit relief afforded by CRT deals. Based on gross credit risk on September 30 2019 of $127bn, the 2018 risk-based rules reduced net risk through CRT by $43.1bn, while the new proposed rule allows a reduction of net risk of only $22.1bn. The new rules also assess gross credit risk to be $151.9bn.

This less generous assessment of the value of CRT transactions in terms of capital relief is based upon such considerations as the capacity of CRT deals to absorb losses and whether the market will be open to new issuance or not.

“These formulas are based upon various assumptions, so they made more conservative assumptions particularly with regard to how much loss the CRT market will absorb. In addition, among other things, the leverage ratio factors in how accessible the CRT market might be in a downturn,” says Warren Kornfeld, a senior vice president with Moody’s in New York.

Common equity - the highest-rated form of capital - is, for example, fully fungible with any business line a firm may operate, but CRT deals cover only losses accrued in a specific pool of home loans. So the FHFA has taken a less generous view of the quality of capital that CRT represents than the 2018 rules.

Moreover, the new rules propose a set of bank-like risk based and leverage capital requirements, and the FHFA says it has looked at bank capital models for guidance. In the past, CRT deals have been troublesome for banks. The typical structure employed by the GSEs, in which exposure detaches at around 50bp of loss and then re-attaches at, say, 4% or 5% requires such high levels of capital by banking regulators that it’s not worth it.

JPMorgan did issue a CRT deal on its mortgage portfolio last year which, eventually, received favourable capital treatment but it’s not a usual path and this probably influenced the FHFA as it sought to impose a bank-like discipline on the GSEs, say sources.

Overall, the new capital rules are significantly more onerous than the 2018 guidelines. Based on assets on September 30 2019, the risk based assessment required $234bn in capital, comprised of common equity Tier 1 in excess of 4.5% of risk-weighted assets (RWA), Tier 1 capital in excess of 6% of RWA and adjusted total capital of 8% of RWA.

The leverage ratio requirement is even more burdensome, coming in at $243bn, based on Tier 1 capital in excess of 2.5% of adjusted total assets plus leverage buffers. The GSEs will have to hold the higher of the two numbers. The 2018 rules proposed total capital of 137bn, so the 2020 rules are 77% higher.

At the moment, the GSEs hold around a modest $45bn in capital, so an increase of this order is no easy task. It can either rely on earnings growth, which at present levels would take possibly a decade, or it can issue equity. The latter is the most expensive route to acquire capital, and following it would likely entail a very different business model for the GSEs.

“The big question is the cost of capital. To get the same return on capital the GSEs will have to, all things being equal, increase their guarantee fees. It’s a business of simple math,” says Kornfeld.

The relative unattractiveness of the CRT market under the new rules might also make the reinsurance market more appealing as a risk transfer route. At the moment, about 75% of the GSE transfer is achieved through capital markets in the form of CAS and STACR deals, and about 25% through the reinsurance market via CIRT and ACIS, but those proportions might shift.

“Credit Insurance Risk Transfers could look more attractive in this environment. Insurers are used to less liquid investments and generally have a longer investment time horizon relative to capital markets players. Borrower forbearance, along with the potential for loan modifications and principal reduction, introduce price volatility risks that make capital markets investors a less stable source of risk capital,” says Bob Gundel, a sales director at RiskSpan.

Of course, at the moment, the CRT market is effectively closed anyway. Prices were crushed in the Covid 19 panic selling and liquidity dried up.

Though prices have rebounded significantly, particularly in the M1s and M2s, it is still not likely that another deal will be priced in the foreseeable future. At the end of this week, M1 CRT deals were in the region of plus 200bp, M2s were around plus 215bp, B1s were perhaps plus 1000bp and B2s were plus 1500bp, say dealers.

“These levels still look expensive to me. Obviously people are still buying, but they’re not the CRT core investors. You need those guys to come back,” adds a trader. The last deal seen in the market was a $966m four-tranche CAS offering by Fannie Mae on March 3, which represented its 41st CAS note.

Fannie Mae and Freddie Mac declined to comment on the new rules.

It might be too soon to write off the CRT market, however. If the new capital rules proposed on May 20 do take effect at some stage down the road, the GSEs may be forced to continue to make use of the structure as they will need every mechanism at their disposal to reduce capital requirements, even if the economic treatment of those mechanisms is less generous than hitherto.

“It’s true that the CRT sector does not offer the same benefit under this proposal, but because the FHFA has increased capital requirements by more than 70%, anything the GSEs can do to reduce capital requirements could be attractive. These rules don’t necessarily mean CRT issuance is de-incentivised,” says James Egan, co-head of securitised products research at Morgan Stanley in New York.

The application of these new capital rules is also a long way in the future. The new rules comprise a 424 page document, and for the next 60 days comment is invited from over 100 market participants. It seems likely this period will be extended.

There might, moreover, be a different incumbent in the White House in January 2021, with different ideas and different appointees, and the plan to release the GSEs from conservatorship could be quietly dropped. Even if it goes ahead, it will take an extended period for the GSEs to meet even a portion of the new capital requirement before they exit conservatorship.

A lot can happen before then.

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