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The impact of construction loans on new Ginnie Mae project loan IO
admin | February 28, 2019
This document is intended for institutional investors and is not subject to all of the independence and disclosure standards applicable to debt research reports prepared for retail investors. This material does not constitute research.
The interest-only tranches of Ginnie Mae project loans usually get the penalties assessed when borrowers voluntarily prepay, and the value of the penalties can overwhelm the lost stream of interest. Loans originated as construction loans have a tendency to prepay faster than more traditional project loans, but construction loans also often come with initial periods that lock out the borrower from prepayment. Faster speeds can help IO value, but lockout can hurt. Analysis of new IOs suggests that lockout hurts more than faster speeds help. There is better value available in IOs with a lower percentage of construction loans.
Lockouts and prepayment penalties
There is a trade-off between the higher prepayment speeds of construction loans, and the fact that these loans are locked-out from prepaying during the construction phase. The lock-out period at loan origination can vary from a few months to four or five years. When the lockout period expires, the loans are subject to prepayment penalties like the other project loans. These penalties are assessed as a specified percentage of the principal amount being prepaid, and the percentage declines over time. A common prepayment penalty scheme is 10% (24) 8%,7%,6%… which means there is a 10% penalty the for the first 24 months, an 8% penalty during the third year, then it declines by 1% each year until it is there is zero prepayment penalty after 10 years.
A brief comparison of two recently issued deals starts to highlight the impact of construction loans (Exhibit 1). Broadly speaking, the two deals have similar collateral characteristics at origination and the IO coupons are 4 bp apart.
Exhibit 1: Collateral comparison of two recently issued IOs
There are two potentially significant differences that could impact IO performance.
- The first is the modest 11% difference in multifamily versus health care loans in the underlying collateral. Health care loans tend to prepay a bit slower and default somewhat more frequently than multifamily loans.
- The second difference is the relatively large 30% difference in the percentage of construction loans at origination. Construction loans are subject to prepay lockout periods. When they exit the lockout period they have a tendency to prepay faster and have a slightly greater default rate.
The collateral backing these two deals is subject to various levels of prepayment penalties over time (Exhibit 2 and Exhibit 3):
- The prepay lockout identifies how the construction loans are rolling out of the lockout period. For the GNR 2018-156 collateral, 30% of the underlying collateral is still in lockout, and the loans with the longest lockouts expire in July of 2020 (Exhibit 2).
- As the lockouts expire, the loans generally transition to the highest level of prepay penalties, where 95% of the collateral is subject to prepay penalties which are greater than or equal to 5% for the next five years (the red line).
- Then the collateral rolls through two declining buckets of prepay penalties, before 80% of the loans has no further prepay penalties in 10 to 12 years from origination, or late-2029.
Exhibit 2: Prepayment penalty profile of GNPL deal with 41% construction loans at origination
Note: Prepayment profiles as of 2/28/2019. Source: Ginnie Mae, Bloomberg, Amherst Pierpont Securities.
The GNR 2018-150 collateral shows a similar prepay penalty profile, with the only significant difference being the much lower percentage of loans subject to an initial lockout period due to the lower concentration of construction loans.
Exhibit 3: Prepayment penalty profile of GNPL deal with 10% construction loans at origination
Note: Prepayment profiles as of 2/28/2019. Source: Ginnie Mae, Bloomberg, Amherst Pierpont Securities.
The smaller percentage of initial lockouts means the prepayment penalty profiles progress to each declining phase a bit faster and ultimately reach the no penalty phase earlier, with nearly 90% of loans subject to no penalty by the end of 2028.
Evaluating the OAS across IOs
The Ginnie Mae project loan model takes all of the nuances and discrimination in the collateral and projected performance differences into account when it analyzes the bonds. Most importantly, it helps balance the impact of lockout, prepayment speed and default across collateral. The impact of different exposure to construction loans shows up in recently issued IOs (Exhibit 4).
Exhibit 4: Comparison of recently issued IOs, arranged in order of OAS from widest to tightest
Note: All prices as of 2/20/2019. Source: Ginnie Mae, Amherst Pierpont Securities.
The dispersion in OAS among these Ginnie Mae project loan IOs is nearly 100 bp, with the two structures detailed above representing the widest and tightest OAS in the group. What is also apparent is that the OAS spread declines steadily with the increasing proportion of construction loans (Exhibit 5).
Exhibit 5: Ginnie Mae project loan IOs – OAS vs % of construction loans in collateral
Note: One outlier, GNR 2019-14 IO not shown for clarity. Source: Ginnie Mae, Amherst Pierpont Securities.
The better value across these structures appears to be IOs with lower concentration of construction loans. The opportunity for faster prepayments sooner in pools with lower construction concentrations seems to outweigh the opportunity for faster prepayments later in pools with higher concentrations. That leaves open the possibility that best relative value could switch as construction loan lockout ends. But for investors in project loan IO off of new pools, the best relative value seems to be in lower construction loan exposure.
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