Mortgage Credit Risk Transfer: Thriving Through The Cycle

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Encouraging stability in the mortgage market

Government sponsored enterprises Fannie Mae and Freddie Mac back about 60% of all US mortgages, making them effectively monoline insurance companies holding large amounts of mortgage credit risk on their balance sheets. They help safeguard the consistent functioning of the mortgage market. To ensure that type of stability, they require diverse sources of capital to transfer risk, including the reinsurance markets. In this episode of Fo[RE]sight, Guy Carpenter experts Jeff Krohn and Tim Armstrong share their insights regarding how the Credit Risk Transfer program de-risks the mortgage industry.

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Eric Stenson: I'm Eric Stenson with Guy Carpenter. Welcome to this episode of Fo[RE]sight, a Guy Carpenter podcast series, bringing you unmatched insights on trending challenges and our solutions delivered by Guy Carpenter experts on the vanguard of thought leadership within the reinsurance industry. Today, Guy Carpenter's Jeff Krohn, Managing Director and Leader of the Mortgage and Structured Credit segment, and Tim Armstrong, Managing Director, will discuss one of the reinsurance industry's most successful public- private partnerships to date, the government sponsored enterprise, or GSE, Credit Risk Transfer Program, and how it has transformed the business models of Fannie Mae and Freddie Mac and serves as the model for mortgage insurers and financial institutions that manage portfolio credit risk.

From a reinsurer’s perspective, they will highlight the advantages of participating in credit risk transfer programs and growing responsibly, as opposed to purely focusing on adding more property risk. Over to you, Jeff.

Jeff Krohn: Thank you, Eric. 2023 marks an important milestone. It's the 10th anniversary of the formation of the government sponsored enterprise CRT or Credit Risk Transfer Program. To date, over $54 billion of credit risk has been transferred to the insurance and reinsurance industry on $3.2 trillion of unpaid principal balance of single-family mortgage loans across 153 transactions. And while transactions have been issued in the capital markets, these insurance and reinsurance transactions have generated $4.8 billion in earned premium to date and an expected lifetime premium of $8.8 billion for the reinsurance industry.

The programs evolved into a steady flow of highly repeatable transactions. And today we're going to discuss some of the takeaways that have led to the success of the program over the last 10 years and how these learnings may be more broadly applied to other portfolios of credit risk. In the context of Fannie Mae and Freddie Mac's credit risk transfer programs, Guy Carpenter acts in the capacity of an adviser and broker transacting in the insurance and reinsurance markets.

As part of every marketing submission, we provide a detailed analytics package that includes deterministic and probabilistic modeled views of the transactions being marketed. Outside of the placement process, we also help educate prospective reinsurers that are considering the GSE Credit Risk transfer program as an avenue for growth and diversification. With me today is Tim Armstrong, who is formerly a divisional CFO with Freddie Mac and will bring an insider's perspective to today's discussion. Welcome, Tim.

Tim Armstrong: Thanks, Jeff. It's great to be here to discuss the success of the Credit Risk Transfer program and other applications of credit risk transfer.

Jeff Krohn: All right. Why don't we start with some of the basics?

Tim Armstrong: Sure. The acronym GSE stands for government sponsored enterprise, which we will use to refer to Fannie Mae and Freddie Mac collectively. Both were established pursuant to separate acts of Congress, which created specific charters that govern the scope of their activities. The core business model of the GSEs is to purchase mortgage loans on single-family homes from banks and non-bank lenders, which creates liquidity and allows those lenders to originate new mortgages. Today, the GSEs fund about 60% of all the mortgages in the US market.

Jeff Krohn: And the GSE-acquired loans are not just any mortgage loan. They're underwritten to very specific standards, right?

Tim Armstrong: That's right, Jeff. In addition, every GSE loan with a loan-to-value ratio above 80% must have a credit enhancement. This is typically in the form of private mortgage insurance. The GSEs then package these thoroughly underwritten mortgages into mortgage-backed securities and distribute the mortgage-backed securities to a broad array of investors around the world. It’s important to note that the GSEs retain 100% of the nonpayment risk of these mortgages, and it’s that credit risk that becomes subject to the credit risk transfer program.

Jeff Krohn: OK—understood. So, the GSEs really exist to ensure that consistent functioning of the mortgage market through time, in good times and bad. To promote stability like that, they need diverse sources of capital, including the insurance and reinsurance markets.

Tim Armstrong: Exactly. And because the housing and mortgage markets play such an outsized role in the US economy, there have been a number of very important reforms and innovations to come out of the great financial crisis that give rise to our conversation here today.

Jeff Krohn: And probably one of the most glaring issues in the lead up to the crisis had to do with the growing number of ill-conceived products that have been introduced to the market, products such as low-documentation, no- documentation, negative-amortization loans. These were all introduced to the market before the crisis.

Tim Armstrong: And my personal favorite chef was the NINJA loan, catering to the borrower with no income, no job, and no assets. So it’s no surprise that things did not work out so well in 2008.

Jeff Krohn: Yes, no surprise to me that those products no longer exist or will ever see the light of day again. Reinsurers would just not allow it. Nor would Fannie or Freddie.

Tim Armstrong: In addition to the elimination of these products, better underwriting standards, including the use of debt-to- income ratios and the introduction of risk-based pricing, have helped meaningfully de-risk mortgage credit. This is really important when you consider that Fannie and Freddie are effectively monoline insurance companies holding massive concentrations of US mortgage credit risk on their balance sheets, with no ability to diversify and no mechanism to transfer risk.

Jeff Krohn: And that conveniently brings us to the establishment of the credit risk transfer program in 2013, designed to reduce taxpayer risk by increasing the role of private capital, while the largest source of capital comes from investors. The reinsurance market plays an almost equally important role, whereas the insurance market plays a distant third. The Credit Risk Transfer program was an important step in the evolution of risk in capital management for the GSEs and really speaks to the importance of having diversified sources of loss-absorbing capital to ensure that they have ready access to that capital in times of stress and the ability to manage through the credit cycle.

The credit risk transfer programs are designed to protect the GSEs against unexpected credit losses on defined portfolios of guaranteed mortgage loans. Under these programs, the GSEs typically retain a multiple of expected loss. Then, reinsurers are on the hook for the remaining unexpected loss up to a level that approaches the GSEs’ capital requirements. In doing so, the GSEs retain expected losses and protect themselves against more severe events, like the global financial crisis, that could compromise their capital position and create the need to rely on a taxpayer backstop to fulfill their mission.

Tim Armstrong: And Jeff, there's a secondary benefit of the credit risk transfer program, in that investors and reinsurers foster market discipline over the GSEs risk-taking activities, increasing the likelihood that the GSEs’ risks are appropriately taking the managed. Without that feedback mechanism, the risks assumed by the GSEs lack an important perspective from other market-based participants.

Jeff Krohn: And reinsurers are not shy about asking questions and sharing their feedback. Tim, Guy Carpenter has been an active participant in the development of both the GSE and the mortgage insurer credit risk transfer programs over the last 10 years. As the programs have evolved and attracted billions of dollars in reinsurance capital, our teams gain some really valuable insights. What are some of those insights that we can share with the audience today?

Tim Armstrong: Well, I think the most important insight that we can share is that transparency has been the overriding theme to the success of these programs.

Jeff Krohn: No surprise there. I mean, transparency creates trust in any marketplace, but it's even more important in a relationship-based market like the reinsurance industry.

Tim Armstrong: And this theme of transparency manifests itself in a few different forms. First, there is transparency in the motivation of buying credit risk transfer. Both the GSEs and the mortgage insurers have regulatory capital requirements that are reduced when risk is transferred to investors, insurers and reinsurers.

Jeff Krohn: And these capital requirements are publicly available. And it’s easy to understand the motivations behind why they engage in credit risk transfer. But all reinsurers also participate on concurrent terms and conditions, don't they, Tim?

Tim Armstrong: Yeah, you're absolutely right. So reinsurers can be confident they are participating on the same terms and won't be selected against.

Jeff Krohn: But the transparency doesn't stop there.

Tim Armstrong: No, it doesn't. The GSEs created additional transparency by putting transaction and performance data in the hands of reinsurers and investors, which in turn paved the path for third-party modeling firms to create analytical platforms. Fannie Mae's data is additionally available through their data dynamics platform, and Freddie's data is available through their platform called Clarity. Prior to CRT, performance data was considered highly proprietary and confidential, but releasing data back to 1999 created trust and attracted private capital, allowing a deep market of investors and reinsurers to develop.

Jeff Krohn: And while transparency may be an overriding theme, the role of consistency can't be overlooked. The reinsurance market craves consistency. In the last year, Fannie and Freddie have placed over 20 transactions, and the mortgage insurers placed over a dozen. In most years, there's just a steady stream of transactions throughout the year, with each placement looking very similar to the last, not only in terms of structure but in terms of underlying credit quality.

Tim Armstrong: And you could see that consistency from transaction to transaction—FICO scores, loan-to-value ratios, debt-to-income ratios are all very stable. If you go back in time, you can also see differences from pre-crisis to post-crisis—FICO scores and other credit metrics are dramatically better.

Jeff Krohn: Beyond the themes of transparency and consistency, reinsurers find the diversification that mortgage business added to their portfolios to be highly attractive and not materially correlated to traditional P&C lines that are exposed to hurricanes, earthquakes and flood. Those types of events have not resulted in meaningful losses to mortgage portfolios, and the data is just so rich in this segment.

It's easy to analyze and quantify with the tools that are available. I don't think there's a class of business that compares to mortgage in terms of the available transactional and exposure data that mortgage offers.

Tim Armstrong: In addition, and unlike other P&C risk, mortgage credit risk offers the opportunity for temporal diversification because of its reliable deal flow, meaning steady participation over time diversifies risk and reduces volatility.

Jeff Krohn: Sounds a bit like the concept of dollar-cost averaging over time to take the volatility out of investment returns, Tim.

Tim Armstrong: Yes, very similar to that. To illustrate temporal diversification, take a mortgage that was originated in 2020 and has benefited from home price appreciation and principal paydowns, not to mention growth in the borrower's income. It has a different risk profile than a recently originated mortgage that has not had any appreciation or principal paydowns. This seasoning reduces the likelihood of default and it is typically the most recently originated mortgages that are the most exposed in a time of stress.

To use your dollar-cost averaging analogy, steady participation in mortgage credit risk avoids the risks associated with trying to time the market.

Jeff Krohn: And reinsurers also point to the favorable capital and ratings treatment they receive as a result of the additional diversification.

Tim Armstrong: Not to mention the favorable return on capital and earnings implications. In fact, one of the reinsurers discloses earnings for their mortgage business as its own discrete segment. For this particular reinsurer, over the last 5 years, mortgages comprised an average of 19% of its premium, but has contributed 93% of its underwriting income.

Jeff Krohn: Whoa—there's more to unpack there, Tim. 19% of premium and 93% of underwriting income from mortgage. I think one takeaway is mortgage has been very profitable. And the other is property casualty has been challenged these last 5 years. And that's consistent with the reinsurance sector composite not earning its cost of capital over those 5 years.

Tim Armstrong: Just one of my favorite stories is about an underwriter who spent his career writing property reinsurance, the largest class of business most reinsurers write. And he lost his company more money than any underwriter before him. Then he switched over to become a mortgage underwriter. And now his colleagues are counting down the days until he breaks even and has made his company more money in mortgage than he lost them in property.

Jeff Krohn: Sounds like an epic celebration is brewing, Tim. I think it's time that the dark and stormy is being replaced by the tequila sunrise.

Tim Armstrong: I hope we're at least invited.

Jeff Krohn: But I digress. Switching topics and recognizing that there are different views on the current economic climate, and some are calling for a brief recession. Let's discuss how the credit risk transfer program performed through the global COVID-19 pandemic. At the onset in early 2020, there were a wide variety of predictions, as unemployment reached 13% and delinquencies rose. Some observers even thought mortgage default rates would reach 25% and that the credit risk transfer programs would be totaled.

Jeff Krohn: But the Federal Housing Finance Agency responded by incorporating lessons learned from the financial crisis to ensure the proper functioning of the mortgage market. For borrowers financially impacted by COVID-19, the GSEs and the FHA allowed homeowners to stop making mortgage payments through a forbearance period. Those that could return to making their regular monthly payments after the forbearance period were allowed to repay missed payments when they sell or refinance the loan.

Tim Armstrong: Simple concept, but the forbearance and loan-deferral programs have been very successful at keeping borrowers in their homes, preventing foreclosures and other distortions in the economy. This innovative approach can be deployed in future stress-response efforts to help maintain the continuous functioning of the mortgage market.

Jeff Krohn: COVID represented a stress test for the mortgage market, but losses have been far less than many feared. To date, the highest loss rate on any single transaction we have seen has been 2 basis points. When those losses are considered relative to attachment points that today are in excess of 50 basis points, it's hard to imagine reinsurers losing money even when you think of the additional losses that may materialize from home price declines.

Some of the bigger banks are projecting home prices to decline by 7% or so, peak to trough. And we’ve already realized about half of that decline. So we'll see what happens, but it doesn't appear anyone is running for the exits.

Tim Armstrong: Two thoughts on that, Jeff. First, it's not an accident that despite the current macroeconomic uncertainty, losses are not materializing at elevated levels. It's really a function of all the permanent reforms that have taken place. Second, these are fundamentally regulatory capital trades designed to protect against very remote risk. Understanding the underlying risk and the purpose of these transactions supports that the credit risk transfer market should be thought of as attractive through the credit cycle, and reinsurers who consistently participate across time fare the best.

Jeff Krohn: That sounds right, Tim. But do you think the recent events at Silicon Valley Bank will impact the credit risk transfer space?

Tim Armstrong: It's the right question to ask, Jeff, but what we know now is that the issues that led to the collapse of Silicon Valley Bank are narrowly focused on US bank balance sheets. 70% of US mortgages are originated by non-banks, which don't rely on their own balance sheets to lend. Now, we may see a general tightening of credit as banks pull back a bit, but credit is already historically tight.

We think there's ample capital available to support US mortgage. So we don't see a meaningful impact on credit risk transfer.

Jeff Krohn: The success of the credit risk transfer programs and the substantial support of the reinsurance industry has attracted the attention of banks and other financial institutions. But it’s clear that not all these financial institutions will be able to unlock the economic value from the reinsurance industry. For some, the reinsurance market will be difficult to understand from the outside looking in.

For others, they believe reinsurers should be approached in the same way as investors or even insurers. But the reinsurance industry has its own customs and practices. Risk appetites evolve, and the markets can be fickle depending on who is approaching them. Knowing your audience is key, and that's where Guy Carpenter can bring domain expertise and deep transactional experience.

So, Tim, let's wrap this up. What are the key takeaways for our listeners?

Tim Armstrong: Well, the attractiveness of mortgage credit risk transfer for reinsurers is clear. It's produced higher returns than any other class of business over the last 10 years. It's uncorrelated to traditional P&C and has a steady deal flow throughout the year. I think those are the key takeaways.

Jeff Krohn: And if you'd like to see the evidence behind our podcast today, please reach out to Tim or me.

Eric Stenson: I'm Eric Stenson and thank you to Jeff Krohn and Tim Armstrong of Guy Carpenter for sharing their insights on the credit risk transfer program and its role in contributing to the stability of the mortgage marketplace. Anyone wishing to learn more or who would like to engage with the Guy Carpenter expert directly should visit guycarp.com com and click Explore Solutions.

Please look for the next episodes in our series as we address additional themes connected with climate, cyber and other key issues affecting the reinsurance environment. And thank you to our audience for sharing this time with us and listening to Fo[RE]sight, a Guy Carpenter Podcast series.