Re-REMICs open a new market for Freddie K investors
admin | December 6, 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.
Freddie Mac recently took a subtle step to improve demand for its multifamily K-deals. The agency opened the first shelf for K-deal re-REMICs, the first deal featuring a long duration, seasoned A2 class at a reduced coupon and a dollar price close to par. By reducing the risk of underperformance if involuntary prepayments accelerate return of principal, the transaction likely improves secondary liquidity by expanding the investor base. There is room for K-deal re-REMICs to expand the base further.
The inaugural re-REMIC
The MBS market has long used re-securitization of existing bonds to restructure cash flows, alter coupons and re-engineer loss profiles typically to improve liquidity or boost ratings. The sharp drop in rates in 2019 has spurred Freddie Mac to open the door to re-REMICs, too. One predictable effect of a sustained rally in rates is that seasoned agency CMBS with higher coupons trade at a significant premium in the secondary market. The downside of the price premium for investors is that the expected yield becomes exceptionally sensitive to achieving the projected cash flows. This takes some investors out of the market for premium bonds.
The inaugural Freddie-K re-REMIC, the FHMR 2019-RR01, was composed entirely of FHMS K078 A2 securities in the pool. The FHMS K078 A2 has a 3.854% coupon, an 8.4 year weighted average life, and currently trades close to $112 (Exhibit 1). This bond is compared to the FHMS K101 A2, which has a 2.524% coupon, a 9.8 year weighted average life, and trades at more modest premium of a 102.74.
Exhibit 1: Scenario analysis of two Freddie K A2 classes
Note: The conditional default rate (CDR) is in percent per annum. Loss severities of 25% were used in all scenarios. All pricing and analysis is from Bloomberg as of 12/5/2019. Source: Bloomberg, Amherst Pierpont Securities
The two securities trade at similar yields in the base case with zero defaults. As the conditional default rate increases from 1% to 6% per year, the A2 classes themselves do not suffer losses, but cumulative losses in the underlying collateral build to 9.9% and 11% in the K078 and K101, respectively. The K101 accrues larger projected losses due to its longer life. As the principal is returned earlier to the A2 classes, due to the involuntary prepayments, the yield drops. The yield on the high premium K078 A2 falls 28 bp from 2.28% to 2.00%, while the yield on the modest premium K101 A2 drops by only 7 bp from 2.20% to 2.14%, despite being longer duration and experiencing higher cumulative defaults in the underlying collateral and larger returns of principal.
The FHMR 2019-RR01 re-REMIC offered an A class pass through with a stripped down coupon of 2.32% to create par priced securities, and an interest only X class with a 1.534% coupon and an assumed price of 10.890625, based on the offering circular. This par issued A class stripped down from the K078 A2 securities would have a substantially more stable yield profile, similar to the K101 A2, in the event that defaults began to build in the underlying loan portfolio.
Not only does the new ability to re-REMIC Freddie K-deals allow more investors to tailor par bonds or interest-only classes, it also allows investors to aggregate a number of bonds with small principal balances into one bond with a larger balance and a broader audience of investors. Re-REMICs should improve demand, liquidity and value in the Freddie K market.
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