In the nascent bond market where U.S. government-backed Fannie Mae and Freddie Mac have insured themselves against losses on $383 billion of home loans, strains are starting to emerge.
Securities that Freddie Mac sold eight months ago, which expose investors to some of the risks on loans the mortgage giant guarantees, fell to 91.4 cents on the dollar this week from more than 108 cents in May. Similar notes issued in July by Fannie Mae traded at even lower prices.
Even as issuance surges sixfold to $10.8 billion this year, investors are showing there are limits to how readily they’ll take on bonds being used to reduce risks to taxpayers. Prices have fallen as investors from TCW Group Inc. to Angel Oak Capital Advisors opt for more traditional debt that they say can offer higher returns or less risk in a market where home prices are rising the least since 2012.
“The reality is you’re making a fairly big bet on the economy and housing market” because the securities are structured in a way that amplifies the risks of homeowner defaults, said Harrison Choi, co-head of securitized products at Los Angeles-based TCW, which oversees more than $144 billion. “That’s not something we’re comfortable with.”
Fannie Mae and Freddie Mac, which were seized by the U.S. in 2008, began selling the securities last year to reduce the odds that taxpayers will again need to offer them aid. In exchange for floating yields as high as 5 percentage points above benchmark rates in the latest offering last month, buyers put up cash that would be used partially to cover losses if defaults rise high enough on mortgages packaged into other securities guaranteed by the companies.
The risk-sharing bonds give policy makers insight into whether they’re charging enough to guarantee mortgages. And it’s a potential model for a future in which the government would bear only catastrophic risk in the $9.4 trillion housing-finance system.
Patricia Boerger, a spokeswoman for Freddie Mac, declined to comment. Fannie Mae spokeswoman Callie Dosberg said that the company has found new buyers for the securities with each of its deals.
“To date over 100 investors have participated in the program,” she said in an email. “The recent spread movements are not unusual or unexpected for a new market.”
A junior, $945 million portion of Fannie Mae’s deal in July traded at 90.5 cents on the dollar yesterday, according to prices reported on the Financial Industry Regulatory Authority’s Trace system. The notes closed at less than 89 cents on Nov. 21.
Columbia Management Investment Advisers LLC says prices may still be too high. That’s because the bonds are linked to a very concentrated portion of default risks, and an investment in the securities can be quickly wiped out when delinquencies increase beyond loss cushions that are built into the debt.
“There is a real potential for principal loss in the subordinate bonds if you have an economic downturn,” said Jason Callan, who oversees about $21 billion as Boston-based Columbia Management’s head of structured products.
While the riskiest portion of Freddie Mac bonds sold in April aren’t impaired as long as a measure of losses in the loan pool stays below 0.3%, the principal is erased when it reaches 2%, according to a report by Kroll Bond Rating Agency, which graded safer pieces of the $966 million deal.
By contrast, some types of mortgage bonds without government backing and created during the housing boom are offering more protection to investors because they have a higher threshold before they’re wiped out and trade at deeper discounts.
Analysts at JPMorgan Chase Co. estimated that even in another housing crisis, an investor in senior subprime-mortgage bonds would earn about the same as benchmark rates, with 46.3% of their principal getting written down. In the same scenario, the riskiest part of a Fannie Mae deal would fail to return 86.4% of investors’ principal, causing steep losses, they said in a report based on mid-November prices.
The Fannie Mae debt offered returns over benchmark rates of 4.25 percentage points without losing any principal under the bank’s base-case scenario of slowing home-price gains. That compared with spreads on the subprime notes of 2.86%, which are projected to lose 29.2% of principal, according to their report.
“I’m still seeing stronger opportunities elsewhere,” said Brad Friedlander, a money manager at Atlanta-based Angel Oak Capital, which oversees $4.2 billion. He said in a telephone interview that he’s finding new mortgage loans, older home-loan bonds and securities backed by high-risk corporate loans more appealing.
Demand for the risk-sharing debt is also being constrained by a limited buyer pool. Insurers’ capital regulations and tax rules affecting real estate investment trusts limit their ability to invest in the debt because of the nature of the securities, according to a report by Paul Nikodem, Pratik Gupta and Rohit Sinha, analysts at Nomura Holdings Inc.
Some investors may also see the notes as lacking the “upside” offered by older private mortgage securities, they said. Because those notes trade at steeper discounts, they can benefit from a better-than-expected housing market or cash windfalls from legal settlements with banks.
The housing market has grown softer this year. Property values as measured by an SP/Case-Shiller index increased 4.8% in September from a year earlier, with appreciation slowing from as high as 10.9% in 2013. At the same time, less than 0.05% of the loans in risk-sharing deals through the first half of this year were at least 60 days delinquent, data compiled by Nomura show.
The “abrupt and steep” slump in the bonds over the past few months can be explained by a lack of liquidity in the market for the securities, analysts at Morgan Stanley led by James Egan and Vishwanath Tirupattur wrote in a report.
Trading of the notes is also likely being hampered by rules that require dealers to hold capital reserves against almost 100% of the debt, the analysts said. The rules allow for a fraction of the amount to be held against older mortgage securities with discounted prices.
Issuance of the securities will likely rise to $12 billion next year if Fannie Mae and Freddie Mac chose to share the same amount of risk on the same types of mortgages, according to analysts led by John Sim at JPMorgan. It could climb an additional $50 billion if the companies look to also curb some of the dangers on older loans they’ve guaranteed since being seized, they wrote in a Nov. 26 report.
“As issuance increases and investor participation grows we should see spread volatility decline,” they wrote. “This should drive spreads tighter and limit the widening that we see around new deal issuance.”