Mortgage-backed securities and credit risk transfer play an integral role in the financial and mortgage markets, helping things move fluidly while reducing risk exposure to the public sector. As an investor and consumer, it's important that you understand how these markets work and how credit risk transfer in particular affects the health of the financial market, economy, and investments.
What are mortgage-backed securities?
Mortgage backed securities (MBS) are groups of real estate mortgages pooled together to be sold as a singular investment on the secondary market. Banks, mortgage originators, and lending institutions create and package loans to sell to private or government sponsored entities, (GSEs) like Federal Home Loan Mortgage Corporation (Freddie Mac), Government National Mortgage Association (Ginnie Mae), or Federal National Mortgage Association (Fannie Mae).
The GSEs securitize the pools of loans, providing a guarantee on the right to collect the principal and interest payments for the loans, selling them on the secondary market. The level of claim provided behind the MBS will depend on the GSE that securitized them, but securitizing the MBS adds a layer of security for the buyer because they know they will get paid regardless if the loan defaults or not. Selling MBS provides liquidity to the loan originator or financial institution while providing a return to the buying institution.
What is credit risk transfer?
Credit risk transfer was created in the aftermath of the 2008 recession as a way to reduce the risk exposure to the public taxpayer, shifting the burden from the public to the private sector.
After a large number of mortgage-backed securities defaulted during the Great Recession, the financial burden to maintain these debt obligations was placed on the U.S. taxpayer, bailing out the financial institutions. To reduce the chance of this happening again, Freddie Mac established credit risk transfer through the Structured Agency Credit Risk (STACR) program in 2013.
Credit risk transfer uses subordination structures to reduce public risk on mortgage-related securities, offering partial guarantees for loans based on the credit quality of the loan pools.
How credit risk transfer works
A credit risk transfer packages different tranches, or groups of loans, into one securitized package. Some of the loans, including the highest credit quality or highest-rated tranches of loans will still receive a GSE guarantee, while other lower-credit quality or lower-rated loans are nonguaranteed. At the time of the credit risk transfer, the total unpaid balance of the loans in the tranche is written down. As pre-payments are received on the loans, for example when a borrower sells the home, paying off the mortgage early or refinances, the unpaid balance of the highest quality tranche that is guaranteed by GSEs are satisfied first. This reduces the total unpaid balance of the debt that is securitized by the public sector and places more risk exposure on the private entity, by having the total balance for the lowest-credit quality loans without a guarantee to remain outstanding.
How it's used in real estate
Credit risk transfer is slowly becoming the primary method for providing liquidity in the financial and mortgage market. As of September 2020, Freddie Mac has created $1.7 trillion in credit risk transfers with $64 billion mortgage risk transferred. Fannie Mae as of Q1 2020 has partially covered $2.19 trillion. These securities are purchased in the private market by money managers, hedge funds, real estate investment trusts (REITs), reinsurers, and insurance carriers, as well as other banks and financial institutions. There are a number of different credit- risk transfer structures provided by the GSEs that focus on providing the right risk exposure for the end buyer. The shift from mortgage-backed securities to credit risk transfer is a long process. Government guarantees will always be enticing to investors and likely won't go away all together. But restructuring how that risk is allocated is better for taxpayers and private investors.