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New issue spreads tighten to pre-pandemic levels

| June 19, 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.

New issue spreads in agency CMBS are trading through pre-pandemic levels and are hovering near all-time tights. This is due to two factors: the lower, steeper yield curve has led to considerable spread tightening and compression across guaranteed classes of varying durations; and the Fed’s agency CMBS buying operations have been so successful supporting the market that the purchase amounts have rapidly declined.

New issue agency multifamily pricing close to all-time tights

The new issue agency CMBS market, anchored by Freddie K-series, has seen spreads begin to approach all-time tights after blowing wider in the middle of March (Exhibits 1 and 2).The peak spreads for new issue was the FHMS K-106 deal which priced on March 17th, when the agency CMBS OAS index was hitting 100 bp, still close to 60 bp below the wides it would touch the following week.

Exhibit 1: Freddie Mac K-deal spreads at pricing, guaranteed classes

Note: Includes standard collateral, 10-year fixed coupon K-deals only. Source: Bloomberg, Freddie Mac, Amherst Pierpont Securities.

The guaranteed A1, A2 and AM classes of the K-106 deal priced at 90, 92 and 95 bp, respectively, while the unguaranteed B and C classes priced at 300 and 400 bp over swaps. By early April the GSEs introduced forbearance plans for single family and multifamily borrowers and the market remained exceptionally skittish about taking on credit risk. Freddie Mac began passing on issuing mezzanine securities in their K-deals in early April in favor of wrapping the collateral into the AM class and increasing the guarantee fee. Since then Freddie has temporarily suspended mezzanine issuance in K-deals, possibly due to the FHFA’s newly proposed capital rules that were published on May 20th.

Exhibit 4: Freddie Mac K-deal spreads at pricing, unguaranteed mezzanine classes

Source: Bloomberg, Freddie Mac, Amherst Pierpont Securities

Lower rates, a steeper curve and the whole panoply of Fed and government programs aimed at easing the economic and market stress due to the pandemic has brought a sense of normalcy back to the market. New issue agency CMBs are coming within a few basis points of all-time tights. The latest K-110 deal which priced on June 17th saw the benchmark A2 class with a WAL of 9.7 recently price at 42 bp, which was 3 bp inside of the A1 class with a WAL of 7.2. This deal had a slightly smaller collateral balance in the A2 class – 68% of collateral compared to a recent average of 73% – and a somewhat larger allocation of over 12% to both the A1 and AM, which on average have 8.3% and 5.1% of the deal balance. The market will continue to sort out how much the liquidity premium is worth in the A2 class and whether investors will migrate to the AMs, and in some cases the A1s, to pick  up additional yield.

The spreads of agency CMBS had been fairly stable for the last several years up until the pandemic broke in early March (Exhibit 3). Spreads peaked in late March during the week of March 23rd – March 28th, with the OAS of a broad market agency CMBS index touching just below 160 bp. The Fed announced on Monday, March 23rd that it would begin buying unlimited amounts of Treasuries, agency MBS and agency CMBS to support the markets, and bolstered that with a range of other credit facilities and lending programs to support business owners and markets.

Exhibit 3: Agency CMBS spreads widen then broadly recover

Note: Bloomberg Barclays Agency CMBS OAS index. The index includes bonds from several types of Freddie Mac K-series incorporating both guaranteed (heaviest weights on A2 classes with some A1, A3 and AM bonds) and mezzanine classes (both B and C), and bonds across classes of Fannie Mae Aces deals. The duration of the index is 5.66 years and there are 786 bonds currently in the index. Source: Bloomberg, Amherst Pierpont Securities.

The agency CMBS index has since broadly recovered, but still remains wide of pre-pandemic levels primarily because over 5% of the bonds in the index are the B and C mezzanine tranches of Freddie K-deals. These unguaranteed classes are part of the credit risk transfer program and function as loss absorbing capital in the unlikely event that losses were to exceed 7.5% of collateral, which is covered by the D subordinate class. The C class would absorb losses from 7.5% to 10%, then the B class would absorb any additional losses between 10% and 14% of the collateral underlying the deal. The surge of multifamily loans in forbearance has resulted in the B and C bonds remaining under some pressure until it becomes clearer what the trajectory of the economic recovery will be and how it will ultimately impact these multifamily borrowers.

Fed agency CMBS operations provided essential support

The Fed’s agency CMBS operations provided critical support that enhanced liquidity, took pressure off of dealer balance sheets and began to normalize spreads. The buying operations were across three multifamily products: Fannie Mae DUS pools, Freddie Mac K-series, and Ginnie Mae project loans. The first operation took place on Thursday, March 27th, when spreads peaked at 158 bp, and was for $1 billion of Fannie Mae DUS pools (Exhibit 2). There is a 3 to 5 bp financing advantage to Fannie Mae DUS pools and Ginnie Mae project loan pools over securitized Freddie Mac K-series, so these tended to be popular instruments for leveraged investors, including hedge funds and mortgage REITs. Similar to the crisis in 2008, though on a much smaller scale, the dramatic increase in financing costs and haircuts applied to collateral forced many leveraged investors into liquidation and their agency CMBS holdings, among others, flooded the street and dealer balance sheets.

Exhibit 3: Fed agency CMBS operations

Source: Federal Reserve Bank of New York, Amherst Pierpont Securities

The Fed’s buying operations in DUS and project loans became heavily oversubscribed, and the Fed twice increased its maximum purchase amount in DUS to $2 billion at the peak in early April before tapering them down as the liquidity and credit crisis began to subside.

By contrast the buying operations in Freddie K-series seldom saw the volume of bids submitted reach the maximum purchase size of the operation, and at each operation the Fed purchases were well below the potential size. In fact, the Fed completely passed on buying any securities during most recent Freddie K operation on June 2nd, perhaps because it did not want to bid at or through market levels to buy a smattering of bonds. Based on how well the market has recovered for agency CMBS and Freddie K-series in particular, its likely the Fed won’t schedule any new purchase operations in that sector.

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