A $50 billion bond market once heralded as the future of housing finance has been stuck in limbo since the start of the coronavirus crisis, and now proposed regulatory changes has investors worrying they will be left holding the bag.
At issue are so-called credit-risk-transfer securities offered by Fannie Mae and Freddie Mac. They are tied to Fannie and Freddie's mortgage-backed securities and pay investors principal and interest as long as the borrowers don't default.
Fannie Mae is the Federal National Mortgage Association and Freddie Mac is the Federal Home Loan Mortgage Corp.
Fannie Mae hasn't issued the bonds since the pandemic began, and the company's executives are privately telling some investors that it has doubts about the market's long-term viability. Freddie Mac, meanwhile, has resumed issuing the bonds after a pause near the start of the pandemic. The lack of activity is starting to worry investors that they will be saddled with securities that are akin to museum pieces that no one is interested in buying.
The uncertainty stems from a proposal by Federal Housing Finance Agency Director Mark Calabria that many say would make it uneconomic in some cases for Fannie and Freddie to keep issuing the securities. Calabria's plan would reduce the capital relief the companies get by issuing credit-risk transfers by about half in some circumstances, according to Chris Helwig, a managing director at Amherst Pierpont Securities.
"There are pretty substantial, existential risks to credit-risk transfers if Calabria goes through with these plans," said Structured Finance Association Chief Executive Officer Michael Bright, whose trade group includes credit-risk-transfer investors.
The credit-risk-transfer market was the result of an effort to change the business models of Fannie and Freddie after they failed and were taken under U.S. control during the 2008 financial crisis.
The two companies don't originate mortgages. They buy them from lenders, wrap them into securities and guarantee the repayment of principal and interest to investors. Before the birth of the credit-risk-transfer market in 2013, Fannie and Freddie largely bore the brunt of losses when borrowers defaulted. Credit-risk-transfer securities pay investors only if borrowers keep paying their mortgages, which protects Fannie and Freddie.
Credit-risk-transfer bonds have a market capitalization of about $45 billion, according to data from market research firm Mark Fontanilla & Co. That's still small relative to the $5 trillion in bonds guaranteed by Fannie and Freddie, but many analysts expected it to mature into a staple of the mortgage-bond market.
All that was thrown into question in May, when Calabria's agency released a proposal for what capital the mortgage giants would have to hold when they exit federal conservatorship.
Even though the proposal hasn't been finalized, the market reacted immediately.
The spread between credit-risk-transfer rates and the benchmark London Interbank Offered Rate widened in June and July after the proposal and remains wide even as pandemic concerns have eased, said John Kerschner, head of securitized products for Janus Henderson Investors.
Fannie hasn't issued any credit-risk transfers since the first quarter, and in its most recent earnings report wrote that even though pandemic-related market stress has eased, the company didn't have plans to issue more of the bonds as it evaluated the proposed capital rule.
At a House Financial Services Committee hearing last month, Calabria came under pressure from both Republican and Democratic lawmakers who sought assurances that the credit-risk-transfer market would continue. He said he believed Fannie and Freddie would still find it economic to issue credit-risk transfers even under the proposed rule.
Calabria was more explicit earlier this month during a conference put on by the Massachusetts Institute of Technology's Golub Center for Finance and Policy, promising that he'd force the companies to keep issuing them while they are under government control. He also made clear, however, that he didn't view credit-risk transfers as being as crucial as other forms of capital.
"It's important to keep in mind that its function in a world where there wasn't going to be an exit from conservatorship and you weren't going to have capital is necessarily going to be slightly different in a world where you do have capital," Calabria said.
If Fannie and Freddie stop issuing new securities, it could become increasingly difficult for investors to trade the bonds they already own as the market and investor base dwindles. Investors, for their part, say they see evidence of the market breaking down.