Fannie, Freddie Risk-Transfer Bonds Give Investors New Scare

  • Prices tracking slump in risky assets on China concerns
  • Market unsettled despite `pristine performance' of mortgages

A nascent corner of the market for Fannie Mae and Freddie Mac bonds is on a roller coaster ride despite what Morgan Stanley calls the “pristine performance” of the mortgages linked to the debt.

Prices of the more than $19 billion of notes, often called credit-risk transfer bonds, collapsed over the past few months, largely tracking a renewed drop in competing assets, such as high-yield corporate notes. Risky bonds are slumping as commodity prices tumble on growing economic concerns about China and other emerging markets. Fannie and Freddie are using their risk-sharing securities to get investors to share in their dangers from homeowner defaults.

The notes initially soared after the taxpayer-backed companies started selling them in 2013, as bond buyers clamored for their better quality loans and a chance to nab high-yielding assets tied to the recovering housing market. But around the middle of last year, as supply expanded and investors sold off other risky debt, they started to crash. Then, as the year was ending, they began to surge again.

Invesco Mortgage Capital Inc. has been one of the bigger investors, with the real estate investment trust holding $666 million of the securities as of June 30. On an earnings call this week, Chief Executive Officer Richard King said the delinquencies on the loans to which the debt is tied are at a “remarkably low level, reflecting the strong underwriting since the mortgage crisis and increasing home values.”

Weakening prices may reflect “increased issuance” meeting a “still developing investor base,” John Anzalone, the REIT’s chief investment officer, said on the call.

Morgan Stanley analysts James Egan, Jeen Ng and Vishwanath Tirupattur wrote in a Wednesday report that the slump presents an “attractive buying opportunity” with the loans performing so well. Defaults on the loans affect whether investors get repaid on debt known as Connecticut Avenue Securities, or CAS, (for Fannie) or Structured Agency Credit Risk, or STACR, notes (for Freddie).

The mortgages are going delinquent “far slower than anything we have seen in recent history,” the analysts said. In fact, loans issued through 2003 -- considered a safe time before the excesses in the housing market took hold -- went bad at a pace anywhere from 1.5 to 6.5 times faster over their first two-to-three years, they wrote.

“Some changes in prices should be expected, especially as prices of other spread products fluctuate,” Andrew Wilson, a Fannie spokesman, said by e-mail. “Overall we’re very pleased with the response from investors who see CAS as a way to invest in Fannie Mae’s unique credit risk management capabilities and the strong performance of the loans covered by these deals.”

The securities have helped the company transfer a portion of the credit risk on about $400 billion of mortgages since 2013, he said.

Mike Reynolds, vice president of credit-risk transfer at Freddie Mac, said in an e-mail that he was pleased that the firm’s notes were “showing more resilience” than corporate securities with junk ratings. The company has laid off some of its potential losses on about $300 billion of home loans with its STACR bonds.

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