In the fifth of six chapters surveying the synthetic securitisation market, SCI highlights the role of reinsurers in US agency CRT
Synthetic securitisation, once tarnished by association with the global financial crisis, has long since come in from the cold. The regulatory framework has developed significantly in Europe since the introduction of the new European Securitisation Regulation in January 2019, culminating in the inclusion of significant risk transfer transactions in the STS regime in April 2021. This label has provided CRT deal flow with additional momentum, broadened the issuer base and helped to legitimise the market.
So, how has the landscape evolved since then? While Europe has historically been the centre of CRT activity, what are the prospects in the US and beyond? SCI’s Global Risk Transfer Report traces the recent regulatory and structural evolution of the capital relief trades market, examines the development of both the issuer base and the investor base, and looks at its prospects for the future.
Chapter five: US mortgage risk transfer
One of the bright spots of the US agency credit risk transfer market this year has been increased allocations to the reinsurance markets via the ACIS and CIRT programmes. Inflation and the resulting widening of credit spreads has dislocated capital market execution via the CAS and STACR programmes and made that option less efficient relative to reinsurance.
Capital market spreads spiked to as high as 200% of 2021 levels amid the volatile market conditions, while reinsurance pricing is up by 60%-80% in the same time period. “Reinsurance pricing would likely not have widened as much as it did, had the capital markets not dislocated, as many view mortgage credit risk to be up in the area of only 10%-20%,” explains Tim Armstrong, md at Guy Carpenter.
Unlike capital market participants, reinsurers don't react to market pricing changes in the secondary market, margin calls - for those investors using leverage - or liquidity premiums. “As a result, reinsurers will absorb three times the limit of liability in 2022 than they did prior to the pandemic,” he adds.
Before the pandemic, agency CRT issuance comprised approximately 75% capital markets and 25% reinsurance markets. Armstrong estimates that this year, reinsurance execution may account for closer to 50% of agency CRT issuance.
The reinsurance platform of Freddie Mac, for one, has run 30%-40% of its total CRT placement this year. Mike Reynolds, vp, single-family CRT programme at the GSE, says: “It has been really well received. We've had a number of new participants in that area. We've seen better price stability out of our reinsurance markets: capital markets executions have been more volatile.”
Freddie Mac’s search for efficiency has proved successful in reducing reinsurance transaction times. Reynolds notes that typically securitisation transactions are executed about four or five months after the MBS execution.
“This year, with the ACIS programme, we’ve actually started to execute transactions at either the same time or even one month forward: we have a hedge for our risk,” he adds.
He suggests that reinsurers have “gotten comfortable with pricing to a proxy pool”.
Indeed, as demand has shifted from the capital markets to reinsurance markets, the flexibility of reinsurance structures has continued to develop. “Several US mortgage insurers have done forward deals on future production, with innovative approaches to matching the detachments to the capital required through time. These approaches have lowered the cost of capital, as they are highly efficient,” confirms Armstrong.
Seamus Fearon, Arch MI evp, CRT and European markets, agrees that forward agency CRT is a natural market for reinsurance because it can provide capacity on a forward basis, which the capital markets struggle with.
Another area of opportunity that he points to is specific pools of cash-out refinance mortgages. These are typically in the 50%-60% LTV bracket, which falls outside the target CRT pool of risk, from 60% LTV upwards. But cash-outs attract quite a high capital charge under the capital rule.
“So, it made sense for the enterprises to try and lay off capital there,” Fearon explains. “We'd seen quite a spike in the number of cash-outs because borrowers have taken advantage of the rapid home price appreciation to take equity out of their homes at historically low interest rates. From a risk perspective, they were lower risk than historically a cash-out borrower would be, so it was a very good trade for the enterprises.”
Overall, Freddie Mac issued unprecedented CRT volumes of nearly US$15bn in the first half of 2022, protecting US$358bn UPB of single-family mortgages. “The volume is primarily driven by our record-breaking acquisitions. We now have nearly a US$3trn book of business. The number one driver is our record-breaking MBS issuance for 2021,” observes Reynolds.
While he describes the ACIS programme as “a tremendous success story” in a rising rate environment, with significant disruption to fixed income markets, he also notes that the floating-rate STACR programme “offers some great protection for investors, given where we are with inflation.”
However, issuance volumes are now declining. “The first half of this year was the largest; the second half is going to be smaller [and] I expect the first half of 2023 to be even smaller still. The Fed will continue to raise interest rates, so I think volumes overall will continue to decrease,” Reynolds predicts.
The best buying opportunities were earlier this year, he adds. “On both the reinsurance and capital markets, the total volumes that we'll be bringing is going to be material and interesting, but it's not going to be anything like what we saw in the first half of this year.”
Nevertheless, Freddie Mac intends to keep increasing the efficiency of its STACR programme. Reynolds says the GSE is seeking to reduce the time it takes to execute STACR transactions.
He also points to Freddie’s tender offers to repurchase outstanding STACR bonds as another area of interest. The first tender offer was launched in September 2021 and the GSE has undertaken one in each quarter of 2022.
“Investors have appreciated the opportunity to be able to sell in bulk. We have a very strong secondary market and August was a very busy month,” Reynolds observes.
Meanwhile, Fannie Mae is still catching up after its pause from the CRT market following the initial draft of the Enterprise Regulatory Capital Framework (ERCF) capital requirements. The ERCF has been tweaked since director Sandra Thompson ushered in a change of guard at the FHFA, but many market participants believe the GSE capital rules should be reviewed further.
Some see the latest changes made to the ERCF as an improvement over the prior version, but the haircuts for CRT remain onerous and unlike those seen in other capital regimes. Others question the degree of CRT issuance, if it were not for the binding constraints of the FHFA scorecard. The haircuts remain a significant disincentive, distorting the risk reduction benefits of the transactions as they disconnect the capital requirement from risk, particularly over time. These weaknesses undermine the real economic value provided by loss-absorbing CRT and reduce the efficiencies of and incentives to use CRT.
Looking ahead, an affordability CRT product covering Fannie or Freddie’s affordable mortgage schemes for low- to moderate-income borrowers could be on the cards. “There will be increased ESG focus, as the FHFA encourages CRT approaches that benefit underserved borrowers,” Armstrong predicts. “The GSE programmes that support these borrowers could become CRT targets, or other loan characteristics may be targeted. We could even see an ESG scoring system introduced to CRT deals to help draw certain investors.”
Delinquencies will also be a focus. “As the US macro market changes in 2023, to the extent that a recession does occur, what kind of impact will that have on delinquencies? That's what the markets will be focusing on,” Reynolds suggests.
Nevertheless, he is optimistic about the future, pointing to sound underwriting and effective loss mitigation. “Every situation is different and past does not predict future performance. But you can see what we did coming out of Covid, with millions of properties in forbearance, and we've come out of that with very little losses. Most of those loans are back to performing.”
The return of MILNs?
“MILN credit spreads remain historically wide, making these issuances less attractive. We don't see meaningful new ILN issuance or innovation, given the current cost of capital available,” says Jeffrey Krohn, md and mortgage and structured credit segment leader at Guy Carpenter.
More attractive pricing is available in the reinsurance markets. In addition to their ongoing deployment of quota share reinsurance, mortgage insurers have increased their use of excess of loss reinsurance as a replacement for MILNs. The growing consensus is that the most durable capital strategy is to use quota share reinsurance, complemented by both excess of loss reinsurance and MILNs.
Seamus Fearon, Arch MI evp, CRT and European markets, anticipates that more insurers will return to the MILN market in the autumn and winter, and hopes to see some spread tightening. “For us, it’s important that we continue to keep those markets active, even if sometimes we have to pay a higher cost than we would like. We are actively working on one deal at the moment and hope to close that by the end of September.”
SCI’s Global Risk Transfer Report is sponsored by Arch MI, ArrowMark Partners, Credit Benchmark and Guy Carpenter. The report can be downloaded, for free, here.
*For more on the outlook for global risk transfer activity, watch a replay of our complimentary webinarheld on 2 November.*