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Prepay exposure jumps in Ginnie Mae project loans

| March 6, 2020

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.

Investors need to prepare for a potential wave of prepayments in Ginnie Mae project loans as the drop in Treasury rates is now deep enough to offset sizable prepayment penalties. After covering penalty costs, up to 95% of collateral in some 2018-2019 deals still have strong incentives to refinance. Investors in project loan IOs should benefit from the large penalties despite hemorrhaging interest payments from many of the higher coupon loans.

Spreads react to coronavirus-driven rally

The flight-to-quality rally that has driven 10-year Treasury rates down to historic lows has had a disparate impact on spreads. Investment grade corporate credit spreads have widened almost 30 bp over the past two weeks while high yield spreads have been driven out by over 100 bp over the same period (Exhibit 1). The agency mortgage basis has mimicked the spread move in investment grade corporates by widening 20 bp, but the widening is driven not by fears of an economic slowdown but by an increase in prepayment risk.

Exhibit 1: Credit and agency mortgage basis spreads

Note: Investment grade and high yield spreads are market value weighted OAS of the US dollar all cash bonds in those sectors as defined by Bloomberg. As of 3/5/2020. The agency mortgage basis is the current coupon 30-year agency mortgage spread to a 50-50 blend of 5-year and 10-year swap rates. Source: Bloomberg, Amherst Pierpont Securities

Spreads of high-quality Ginnie Mae project loans have widened modestly from a multi-year low of 105 bp out to 110 bp, in-line with the widening in Fannie Mae DUS 10/9.5 and Freddie K-deal 10-year A2 classes (Exhibit 2). The prepayment risk in agency CMBS is muted by the prepayment penalties attached to the loans, so agency CMBS spreads don’t tend to widen as much in a rally as spreads of agency MBS.

Exhibit 2: Agency CMBS spreads, 10-year weighted average life

Note: As of 3/5/2020. Source: Amherst Pierpont Securities

Prepayment risk in Ginnie Mae project loans

Fannie Mae multifamily DUS loans typically incorporate yield maintenance provisions for borrowers who want to prepay their loans, and loans in Freddie Mac K-deals require defeasance. In both cases there is no impact from prepayments to the investors for the agency guaranteed classes. By comparison, Ginnie Mae project loans use a declining points system of prepayment penalties. Though the penalty points can vary considerably across loans, the most common form is for a loan to have a 10-point penalty in the first year, a 9-point penalty the second year, and so on down to 1-point penalty the tenth year. After ten years the loan is typically in the open period and there are no penalties attached to prepayment.

Exhibit 3: Historical project loan rates vs 10-year Treasury rate

Note: Monthly average rates, lagged to adjust for delay between loan origination and deal pricing. Updated through February 2020 which reflects January 2020 origination. Source: Amherst Pierpont Securities

Coupon rates on project loans originated at the same time exhibit a significant amount of variance, but it’s possible to back out an average par coupon project loan rate (Exhibit 3). The spread between aggregate project loan rates and 10-year Treasury rates has averaged 140 bp over the past five years. That spread does tend to widen when rates get very low and has hovered between 150 – 175 bp for the last year. Assuming a 10-year Treasury rate of 0.75% as of March 6 plus a 150 bp spread puts the current Ginnie Mae project loan rate at 2.25%.

Adjusting the refinance incentive for penalty points

Evaluating the refinance incentive for a Ginnie Mae project loan starts with covering the cost of any penalties. Borrowers rarely want to take cash out of pocket. Instead, they often aim to take a new loan that trades at a premium in the secondary market. The premium loan generates excess cash to the lender, and the borrower uses the cash to pay penalties and adds the amount to the new loan balance.

To figure out the new loan rate that will generate enough excess cash, investors need to look at the project loan IO market. For example, the GNR 2019-9 IO has a multiple of 10.5. A borrower financing a 10% prepayment penalty adds needs a loan with a coupon 94 bp above the par rate since 95 x 10.5 = $10. For borrowers looking to get out of an existing loan into a new loan with a standard maturity and penalty schedule, the current at-the-money par coupon project loan rate varies from 3.20% for a loan with a 10-point penalty to 2.35% for a loan with a 1-point penalty (Exhibit 4).

Exhibit 4: Example of penalty-adjusted par coupon rates (GNR 2019-9, IO multiple = 10.5)

Note: IO multiple = IO price / IO coupon; Cost of penalty = penalty * 100 / multiple. The current par coupon project loan rate is assumed to be 2.25%. The IO multiple is assumed to be 10.5  Source: Bloomberg, Amherst Pierpont Securities

The GNR 2019-9 came out in January of 2019, and most of the loans in the deal currently have prepayment penalties of 9 or 10 points. The penalty-adjusted refinance incentive for the 15 largest loans in the deal varies from a high of 151 bp to a low of 57 bp (Exhibit 5). Assuming a borrower requires at least a 25 bp incentive, 63 of the 74 loans comprising 96.6% of the collateral in the GNR 2019-9 deal currently are in-the-money to refinance. Six of those loans comprising 2.4% of the collateral have a penalty adjusted refinance incentive of 25 – 50 bp. The other 11 loans are currently in lockout.

Exhibit 5: Refinance incentive for largest loans in GNR 2019-9

Note: There are 74 loans in the GNR 2019-9 deal, 11 of which are still in lockout. The current par coupon project loan rate is assumed to be 2.25%. Source: Bloomberg, Amherst Pierpont Securities

Project loan deals issued in 2018 through mid-2019 tend to have higher weighted average coupons because that coincides with the most recent period that 10-year Treasury rates were above 2.50%. Given the dramatic rally, a lot of those loans are at least 25 bp in-the-money to refinance on a penalty-adjusted basis. Refinancing a project loan with Ginnie Mae can take up to three months, so prepay speeds could stay elevated through June. Investors in 2018-2019 GNR IOs should benefit from the large penalties despite hemorrhaging interest payments from many of the higher coupon loans.

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