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A big risk transfer innovation that was a long time coming

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Fannie Mae has a mandate from its regulator to offload the bulk of credit risk on residential mortgages it insures to capital markets investors. For better or worse, the funds it raises by issuing credit risk transfer securities serve as an important form of capital for the government-sponsored enterprise.

Yet participation in Fannie Mae’s benchmark risk transfer program, Connecticut Avenue Securities, by an important class of investors has been limited. Real estate investment trusts are considered to be a natural buyer because of their appetite for this kind of risk: They must invest at least 75% of their assets in real estate. CAS, as they were originally designed, did not qualify, however. Though the performance of the bonds was linked to a reference pool of mortgages insured by Fannie Mae, they were technically general obligations of the company.

The latest CAS, which priced this week, is structured instead as a bankruptcy remote trust. Proceeds from the bonds are deposited in various investment accounts; they do not sit on Fannie Mae’s balance sheet. They are only available to the GSE should losses on the reference pool of loans reach a predetermined level.

“This has been a huge goal for us, practically since the beginning of the program,” said Laurel Davis, Fannie Mae’s vice president, credit risk transfer. “It’s a big innovation that has been a long time coming.”

Switching to a REMIC structure accomplished something else that Davis says is important for the long-term success of the program: It eliminates the risk that Fannie Mae might not, at some point in the future, be able to make good on its obligations.

In an interview this week with Asset Securitization Report, Davis explained why CAS was not structured as a REMIC when the program was launched in 2013, why the process took so long and how the REIT community has responded. An edited transcript follows.

ASR: Why is the REMIC structure important?

LAUREL DAVIS: The biggest improvement is that it allows all of the notes issued in CAS transactions to be treated as debt for tax purposes. This is a huge difference. It helps facilitate participation by international investors and it also helps broader participation from REITs. The other benefit from a REIT perspective is that we designed the structure to meet all of the REIT good income and good asset tests, which existing CAS notes did not meet. That’s an important consideration, both from a tax and from a legal perspective. We believe REITs are a natural source of capital for investing in mortgage risk. This is more of a long-term consideration, but by issuing out of a REMIC trust, we are getting rid of investor counterparty exposure to Fannie Mae. That’s not an issue today, but we want the program to be sustainable in the long run, so limiting counterparty exposure is an important change.

Why not do CAS as REMICs in the first place?

To have started using a REMIC structure we would have needed legislation to change the REMIC rules themselves. Instead we worked to find a way to achieve this treatment through the deal structure itself. It took a while to figure out. The key was to begin to make a REMIC election on the underlying loans as we acquire and securitize them into MBS. We started doing that in May of this year. While that sounds really simple, we wanted to make sure that anything we did would keep the MBS TBA market intact.

Does Fannie take this election on all of the loans it acquires?

It’s essentially all of the loans we acquire, or around 99.9% of them. There are a handful of MBS prefixes that, in and of themselves, are not REMIC eligible, such as loans with LTVs of over 125%. But there is very little volume.

Did the deal attract more REITs?

We did. I was a little surprised to see more REIT activity on this very first deal, because we made these changes more as a long-term play. We expected to see participation broaden over time. I was happy that we saw new REIT money already coming in. We did an extensive roadshow and received a lot of feedback.

How much REIT participation has there been in the past?

For the program to date, it has been just under 5%, but it varies by class of securities. The highest participation has been in the M2 class. There has been less in the B-1 because of the tax treatment. It will be interesting to see if participation in the B-1 expands. Those bonds could be a natural fit for REITs now that they are considered debt for tax purposes. Even REITs that held them before couldn’t hold them inside their REITs. Apart from the REMIC election, we kept the structure of the deal very much the same. The classes of offered notes, cash flows, loss calculations are all consistent with prior deals. Investors value the consistency of the program, which is part of the reason why it’s become so liquid. Roughly one times the float — there are about $25 billion of CAS securities outstanding — traded over the past 12 months.

Did Fannie Mae make any changes to the structure as a result of feedback from REITs?

We did make some tweaks. After we began taking the REMIC election on loans starting in May, we reached out to Nareit as well as a number of individual REITs, and we received some great feedback. For example, we structured the transaction so that it does not contain any underlying swaps, and therefore any considerations regarding commodity pool operator rules are not applicable. That has a benefit for some investors, especially REITs. Also, we provide a Data Dynamics tool on our website that shows how deals perform, and we added some tools specifically for REITs that allow them to monitor investments from a good REIT income perspective.

Were you happy with the execution?

Definitely. Given the given backdrop of all market volatility we’ve seen over the last month, we expected credit spreads to widen. However, within that context, the deal priced well within our expectations, in the middle to the tight end of the guidance range.

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Credit risk transfers RMBS REITs GSEs Fannie Mae