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Impact of defeasance on Freddie K-deal spreads

| September 13, 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.

Strong property price appreciation in the multifamily sector and low interest rates have contributed to an uptick in defeasance in Freddie K deals – a trend that is likely to continue building over the coming months. An increase in the level of defeasance is one of the primary drivers of spread tightening, and eventually ratings upgrades, on the B and C classes of these deals. The impact of an increase in defeasance on spreads varies based on the percentage of the deal already defeased and the weighted average life of the bond. Such an increase has the largest effect on spreads at very low levels of defeasance.

A rising tide of defeasances and the resulting bond upgrades was highlighted in Ratings transitions in Freddie K deals, published August 9th, 2019. Ratings upgrades have started trickling through, with analysts at Kroll Bond Rating Agency (KBRA) upgrading two Freddie K deals at the end of August (excerpt from CMBS Trend Watch August 2019, page 6):

FREMF 2012-K23
The ratings on Classes B and C were upgraded by one and two notches to AA+ (sf) and A+ (sf), respectively. The upgrades primarily reflect the continued improvement in the pool’s credit performance as well as defeasances. Since KBRA’s last ratings actions in August 2018, 15 loans totaling $166.3 million (13.3%) have fully defeased.

FREMF 2014-K503
The ratings on Classes B and C certificates were upgraded by two and five notches to AAA (sf), respectively. The upgrades reflect the paydown of the underlying trust such that the amount of fully defeased loans is in excess of Classes B and C, the only remaining rated principal classes.

Ratings changes by nature tend to be a lagging indicator of credit performance. Investors respond quickly to new information and spreads incorporate changes in credit metrics soon after data is released. The sheer number of quantitative and qualitative credit metrics that are tracked on a loan by loan basis for commercial real estate can be daunting, but analyzing and projecting performance of Freddie K-deals can be distilled to a handful of factors.

Strong underwriting and calm markets

Freddie K-deals are typically comprised of diversified pools of loans on stabilized multifamily properties which satisfy the agency’s strict, arguably exhaustive, underwriting criteria. Credit performance has been impressive, with zero credit losses on the guaranteed classes and only $15.3 million in total losses realized by B-tranche investors – representing less than 1 basis point of total issuance – in the history of the program. A comprehensive look at the Freddie K program, including performance details, is available in  Freddie Mac’s multifamily securitization overview.

The strength of the program, the reasonable liquidity provided by broker dealers, and the relative calm of the multifamily market post-crisis simplifies the performance analysis. Not surprisingly, the level of defeasance in a deal is one of the most significant determinants of spread for Freddie K-deal B and C tranches (Exhibits 1 and 2).

Exhibit 1: B tranche deal spreads vs defeased percentage

Source: Bloomberg, Amherst Pierpont Securities

The relationship between the spread to swaps of the B or C classes and the level of defeasance in the deal is non-linear, though the non-linearity is much more pronounced in the B piece spreads. Both B and C classes show the greatest compression in spread as defeasance increases from 0% to 15%, with B class spreads tightening on average by 75 bp, while C class spreads tighten by 50 bp. In B classes, which have more credit support at origination than Cs, the rate of spread tightening as defeasance levels rise above 15% slows rather quickly. It requires an increase in defeasance level to 40% for spreads to tighten from 75 bp to 50 bp.

The rate of spread compression for C tranches stays roughly constant as defeasance increases from 15% to 30% and spreads tighten roughly another 50 bp. Above 30% defeasance the spread tightening in C classes slows down markedly, with an increase in defeasance levels from 30% to 60% tightening spreads by about 25 bp from 100 bp to 75 bp.

Exhibit 2: C tranche deal spreads vs defeased percentage

Source: Bloomberg, Amherst Pierpont Securities

The differing dynamic in spread tightening between the Bs and Cs in part reflects the greater credit support of the Bs at origination.

There is also a somewhat wide diversity of ratings  across various defeasance buckets. Although much of the spread tightening occurs as defeasance levels and other credit metrics are reported, an upgrade can attract investors who are sensitive to ratings categories due to regulatory or other eligibility criteria.

Monitoring deals for ratings upgrades

A ratings transition matrix for most Freddie K-deal B and C tranches as of September 12, 2019 is available here. Although the link is to a static version, an Excel version is available that automatically downloads data from Bloomberg for investors who would like to keep track of potential and recent ratings actions. Please reach out if you are interested in having a copy.

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