Credit Risk Transfers: Investor and GSE Perspectives

Abstract

In 2013, the government-sponsored enterprises (GSEs) began issuing credit risk transfer (CRT) transactions in order to transfer some of the credit risk on the mortgages they were guaranteeing to private investors. This article analyzes these CRT transactions from the investor and the GSE perspectives. The authors use two different approaches to project performance on the underlying collateral behind these deals. First, they project collateral performance under a set of generic default and prepayment assumptions and run the resulting cash flows through their CRT cash flow waterfall engine. They use results from this iterative process for each deal to determine a CRT breakeven default level above which the credit-protection benefit provided to the GSEs exceeds the cost to buy that protection from investors. Then, the authors run the mortgages underlying the four different Freddie Mac deals through their recently developed loan-level agency credit model described in the Spring 2014 issue of The Journal of Structured Finance to produce an empirically grounded set of collateral cash flow projections. Using various housing-price and unemployment-rate assumptions specified in the Federal Reserve’s 2014 Comprehensive Capital Analysis and Review (CCAR) stress tests, they observe that under the CCAR “Severe Adverse” scenario, only the most subordinate tranche of the CRT transactions would be written down and see negative returns, while all investor-held tranches would see positive returns under the more optimistic CCAR “Base” and “Adverse” scenarios. This analysis suggests that the CRTs would provide valuable protection to the GSEs under the “Severe Adverse” scenario or a repeat of the Great Recession.