Dwindling supply could be a boon for CRT stocks

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By Jose A. Pluto

Record agency CRT issuance has 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 pools of mortgage loans that they package in securities. CRTs provide capital relief by absorbing credit losses on mortgages that GSEs insure.

Record mortgage issuance in 2021, combined with Fannie Mae’s reinvigorated CRT issuance, has sought to boost overall CRT volume from $30 billion to $40 billion this year, more than double the record of annual issue. Spreads widened as $19 billion of new CRTs hit the market in the first half of the year.

Today, CRT issuance is slowing as demand for mortgages has waned and GSEs are opting to hold on to the most subordinated CRT bonds. As a result, gross CRT issuance for the remainder of 2022 will likely drop to around $8 billion.

Better still, for the CRTs, the GSE call for tenders activity has accelerated. Since the end of 2021, Fannie and Freddie have repurchased nearly $11 billion in outstanding CRT securities.

Here’s why: CRT bonds amortize alongside the mortgages they insure, with the most senior tranches of a CRT receiving principal payments first. This means that the cost of GSE insurance increases over time, even as borrowers pay off their mortgages and reduce their leverage. At some point, the cost of this insurance is greater than the capital relief it provides to GSEs. This dynamic is accentuated when house prices appreciate, as they have done for much of the year.

While CRTs contain call options that allow GSEs to repurchase these securities, they tend to have 5-year lock-in provisions. Meanwhile, rising prepayments and rising house prices are forcing GSEs to act now – hence the expected increase in CRT bidding.

We estimate that an additional $4bn of pre-Covid issued CRTs could be tendered in the next 3-6 months, or approximately 7% of total debt outstanding CRT. The credit enhancement of these securities has increased three to five times since their issuance, and they include underlying loans with an average loan-to-value ratio of less than 50%.

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

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