Recession Fears Hit Risky Mortgage Debt Amid Default Concerns

Investors unload securities sold by Fannie Mae FNMA -2.02%

and Freddie MacFMCC -1.92%

shifting the risk of mortgage defaults away from taxpayers, a sign of growing concerns about defaults as rising interest rates cause a severe recession.

The securities, known as credit risk transfers, could suffer losses as mounting defaults creep into the massive swathes of mortgage debt backed by the real estate finance giants. The Federal Reserve’s rate hikes have shown signs of cooling in the housing market raging from the pandemic, and many fear the central bank’s anti-inflationary efforts could cause a recession that will hurt homeowners’ ability to pay off their loans.

That has unnerved some investors holding securities tied to riskier cash flows from mortgage debt backed by Fannie and Freddie. Money managers, pensions and hedge funds are all investing in the roughly $60 billion CRT market, which acts as insurance for the two agencies against roughly $4.5 trillion in defaults on mortgages that would otherwise incur losses for the US -taxpayers would mean.

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As the clouds darken over the housing market and the economy at large, investors are letting CRT prices fall and demanding higher compensation to keep them. As of last week, typical junk-grade CRTs are yielding 6.75 percentage points more than ultra-safe U.S. Treasuries, according to JPMorgan data.

Barring a surge in the early days of the Covid-19 pandemic, this is close to the highest since CRTs were introduced a decade ago. This January, the relative spread versus Treasuries was just 3.42 percentage points.

Last week, spreads on junk corporate bonds with a comparable single-B rating were lower at 5.43 percentage points, according to index data from the Intercontinental Exchange,

This reflects the market perception that CRTs are riskier.

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Fannie and Freddie don’t give out loans. Instead, they wrap other lenders’ mortgages in securities and sell them to investors, guaranteeing payment if the underlying mortgages default.

Credit risk transfers are not associated with this guarantee. Instead, they appeal to investors who want higher returns in exchange for the risk of downside when widespread mortgage defaults reach even relatively modest levels.

Mortgage rates are rocketing, hitting a two-decade high at 6.92% last week. With affordability squeezed, the housing market was one of the first corners of the economy to falter, reducing the attractiveness of CRTs relative to other corners of the bond market, said Paul Norris, head of structured products at investment manager Conning. He thinks prices could fall further from here.

“Housing has been at the forefront of the current malaise,” Mr. Norris said. “I want to be able to go to the client and say that I really believe in this asset class, but I can’t argue that yet.” Conning has avoided CRTs and favored other junk-rated structured finance securities lately, he said.

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CRT prices have fallen so much that, based on spreads alone, the market is preparing for a housing crisis as bad as the 2008 recession, said Ben Hunsaker, portfolio manager at Beach Point Capital Management.

Today, investors largely agree that risks in the mortgage financing system are better contained than they were in the mid-2000s, when some risky mortgage bonds helped trigger the 2007-2008 financial crisis.

Since then, Fannie and Freddie have operated under government supervision, with stricter credit standards for the mortgages they guarantee. Introduced in 2013, CRTs are an attempt to shift some of the risk of mortgage defaults to retail investors.

A series of rate hikes has swept the US economy and more are forecast to follow. The WSJ breaks down the numbers hitting Americans’ wallets this year and beyond. Photo: Elise Amendola/Associated Press

Some of these investors, undaunted by the bleak prospects for the housing market, are betting that the recent sell-off in CRTs has been overdone. Real estate could falter in a coming recession, but defaults are unlikely to reach the levels they reached overall 15 years ago, Mr Hunsaker said. Instead, he blamed part of the sharp drop in CRT prices on sales of the securities by big money managers as clients dumped their money from pension funds amid this year’s historic market crisis.

Beach Point has been buying CRTs this year, focusing on those tied to mortgages homeowners signed in 2020 and 2021. Despite the recent fall in house prices, values ​​are still up on last year, which is weighing on the finances of those households, Mr Hunsaker said. Also, the interest rates CRT investors receive rise and fall with market rates — unlike most junk bonds — protecting investors like Beach Point from the risk of further rate hikes by the Federal Reserve.

“Housing construction today is undeniably worse than it was a year ago, but as we delved into the market, we found it difficult to underwrite the bear thesis,” Mr Hunsaker said.


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Another potential boon for CRT investors: Fannie and Freddie last year offered to buy back billions of dollars worth of CRTs, moves that could push prices higher by reducing the supply of credit. Conversely, in 2022 investors had expected a flood of new issues, which did not fully materialize.

The two agencies pay CRT investors a floating rate, but interest payments on homeowners’ mortgages are fixed. So when interest rates rise, it may be more economical for agencies to buy back CRTs than pay ever-increasing interest rates.

That’s one of the reasons investment manager Brandywine Global also invested in CRTs this year, said Tracy Chen, the firm’s portfolio manager. She believes the sell-off was driven by market technicals rather than underlying risks in the home finance system.

“The quality of the loan is exceptional and the underwriting is pretty solid,” she said, citing healthy household balance sheets and the high average loan values ​​typical of recent mortgage borrowers. CRT prices, on the other hand, seem to reflect expectations of a serious housing shortage, which Ms. Chen doesn’t think is likely.

“I don’t think spreads that big are sustainable,” she said.

Write to Matt Grossman at [email protected]

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