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Avoiding forbearance risk

| July 17, 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.

Multifamily loans in forbearance currently range from 1.3% to 2.6% of outstanding balances across Fannie Mae and Freddie Mac although some subsectors, such as small balance FRESB loans, have forbearance rates as high as 10%. The resurgence of Covid-19 and renewed shutdowns in several states have coincided with the looming expiration of supplemental unemployment benefits at the end of July. Another fiscal stimulus package may come, but it is likely to be less generous and may not pass until mid-August. The additional stress on tenants and multifamily borrowers could cause the pace of forbearance to rise sharply by the end of August. Investors should continue to be wary of high concentrations of senior and student housing and avoid low- to middle-income housing in states such as Texas, New York and Florida. Most standard, fixed-rate Freddie Mac K-series deals continue to have plenty of protection from potential defaults even for B and C classes. Investors might consider avoiding high premium A1 classes in deals with high levels of forbearance, or have the premium risk reduced by stripping down the coupon in a re-REMIC structure.

For all 156 Freddie K-deals with at least one loan in forbearance, the average percentage of the deal balance in forbearance is 5.2%. Assuming 25% of the loans in forbearance eventually default, and the loss severity is 40%, the expected losses would be 5.2% * 25% * 40% = 0.52% of the collateral balance. This is still comfortably below the typical 7.5% of protection provided by the first loss piece. Even if 100% of the loans in forbearance defaulted, that would result in average expected losses of 2.08%. However, some of the specialty K-series have much higher rates of forbearance (Exhibit 1). The ones with the highest levels of forbearance tend to be those with less diverse pools or chunkier loans.

Exhibit 1: Top 20 Freddie K-deals with loans in forbearance

Note: Forbearance data as of 6/26/2020. Source: Bloomberg, Amherst Pierpont Securities

There are 68 standard, fixed-rate K-series deal that have at least one loan in forbearance. These deals average just 2.3% of the deal balance in forbearance. The highest level of forbearance among the standard K-series is the FHMS K045 deal with four loans currently in forbearance comprising 8.4% of the deal balance (Exhibit 3).

Exhibit 3: Breakdown of loans in forbearance by property type for particular deals

Note: Forbearance data as of 6/26/2020. An Excel workbook is available upon request with these tables that can be used to see the breakdown of loans in forbearance by property type for any Freddie Mac FHMS or FRESB shelf deal. Source: Bloomberg, Amherst Pierpont Securities

The K045 has 4 loans in forbearance: three multifamily garden properties that comprise 2.9% of the outstanding deal balance and one student loan property that is 5.4% of the deal balance. For the sake of argument assume the student loan property eventually defaults. As discussed above, the issue is not that the FREMF B or C classes of the deal would even be remotely threatened with a loss, given the substantial amount of first loss protection.

However, the A1 class of this deal currently has $108 million in outstanding balance, a 2.49% coupon, and an estimated price of just a few eighths below 104 (based on Bloomberg BVAL pricing). The projected yield at 0 CPY is 0.665%. A default on that loan would result in an involuntary prepayment of nearly 77% of the outstanding balance of the class. Depending on when the prepayment occurred, the projected yield could be substantially lower or potentially turn negative. One strategy for owners or potential buyers of these kinds of high premium classes is to re-REMIC the collateral and have the coupon stripped down, which significantly reduces the potential for lower yields due to faster prepayments.

Preparing for an uptick in forbearance

The economic recovery has deteriorated over the past month and low- to moderate-income renters are experiencing or expect additional losses in employment income (Exhibit 3). Housing insecurity – which is the percentage of adults who missed last month’s rent or mortgage payment and don’t think they can make their next payment – rose to a new high of 25.9% at the end of June (Exhibit 4).

Exhibit 4: Household Pulse Survey – Total US

Source: US Census Bureau

Renter households as a group tend to be lower income, have less education and are much more likely to have suffered job or income losses during the pandemic. Not surprisingly, housing insecurity is higher among renters, with 30.6% nationally reporting slight to no confidence in their ability to make their next rent payment during the survey week of July 2 – July 7, 2020. In hard hit areas such as New York, Texas and Florida, the proportion of homeowners and renters facing housing stress is significantly higher (Exhibit 5). For example, in New York fully 36.3% of renters report they will struggle to make their next rent payment.

Exhibit 5: Household Pulse Survey – Housing Insecurity by state

Note: Results shown are for Week 9, June 25 – June 30, 2020. Source: US Census Bureau

Congress and the Administration will eventually pass a new stimulus package that should alleviate some of the stress, but the ongoing pandemic looks likely to slow the return to normal levels of employment. Hopes for a v-shaped recovery are gone, and a longer, more drawn out crisis could ultimately result in higher rates of forbearance and eventual defaults.

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