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Forbearance casts a shadow over A1 classes across K-deals
admin | July 24, 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. This material does not constitute research.
Pressure on multifamily tenants and borrowers continues to build, with Freddie Mac having the greatest percentage of multifamily loans outstanding currently in forbearance among the agencies. These totals are almost certain to rise when new forbearance numbers are reported at the end of July. Defaults could begin appearing in October as the extended forbearance period ends. Investors in the mezzanine B and C classes of standard Freddie K-deals are well insulated from credit losses, and the projected performance across several different default scenarios is quite stable. It is the A1 classes, wrapped by the agency guarantee, that are most at risk of underperformance from accelerated repayment of principal.
Exhibit 1: Freddie Mac multifamily loans in forbearance
Note: Forbearance data as of 6/26/2020. Source: Bloomberg, Amherst Pierpont Securities
In a sequential pay structure, the A1 class is the first to absorb the involuntary prepayments of principal that arise from defaults (Exhibit 2). The credit losses are first absorbed by the D class, which is typically 7.5% of the collateral pool. It would require defaults of 18.75% of the collateral pool at 40% loss severity to exhaust the credit protection of the D class (7.5% / 40% = 18.75%). Credit losses would then flow sequentially up to the C and B classes. No C or B class of a K-series has taken any credit losses to date. Among standard K-series that have loans in forbearance, the average percentage of the deal balance in forbearance is 2.4%.
Exhibit 2: FHMS/FREMF 2015-K45 structure
Note: The 2015-K45 deal currently has the highest percentage of loans in forbearance (8.4%) of all standard K-series deals. Source: Bloomberg, Amherst Pierpont Securities
The credit protection provided by the D classes is almost certainly sufficient to protect B and C class investors in standard K-series deals. The biggest risk for underperformance among the fixed-rate classes of standard K-series deals is actually in the A1 class, due to the acceleration of the return of principal from defaulted loans. As an example, consider the 2015-K45 deal (Exhibit 3). It currently has the highest percentage loans in forbearance of all K-series deals (8.4%). Moreover, the outstanding principal balance of the four loans currently in forbearance is greater than the outstanding balance of the A1 class (118%).
Exhibit 3: Loans in forbearance in FHMS/FREMF 2015-K45
Source: Bloomberg, Amherst Pierpont Securities
Projected performance of the fixed-rate classes of the 2015-K45 deal under three different default scenarios is shown in Exhibit 4. If the two loans highlighted above default under the targeted scenario, 81% of the collateral of the A1 class will be prepaid at par in March of 2021, resulting in a projected yield of -4.1% compared to an expected yield of 0.63% given zero defaults. With the exception of the loss absorbing D class (which is not part of the public offering to investors), the A1 has the worst performance among the fixed rate classes in these scenarios.
Exhibit 4: Projected performance across default scenarios
Note: All scenarios assume a 40% loss severity and 0 CPY. The targeted loans scenario assumes the two loans highlighted in Exhibit 3 default in October 2020 and workout / prepayment occurs in March 2021. The base 1 scenario assumes a high spike in default rates followed by a quick recovery, while the base 2 scenario assumes a slower rise in defaults but an extended recovery period. A complete description of the scenarios, along with default and loss rate projections are shown in appendix. The cumulative losses in the base case scenarios are not as high as shown in the graphs because some of the collateral in this deal is already defeased. Source: Bloomberg, Amherst Pierpont Securities
The risk of underperforming A1 classes rises based on the higher the price premium and the larger the level of defaults / prepayments compared to the size of the class. Investors should monitor the size of the loans in forbearance versus the size of the A1 class across deals. Underperformance can creep towards the A2 if enough of the A1 class is prepaid that it spills over or shortens the average life of the A2 as well. In several older deals with loans in forbearance, the A1 class is already paid off and the A2 will receive any principal returned (K013, K014, K017 and K018).
Appendix: Default and loss scenarios
Two possible base case default scenarios due to the impact of the COVID-19 crisis were outlined in the piece Projecting agency multifamily default scenarios of May 15, 2020. The first plausible base case is a short, but high spike in default rates, which resolves as the multifamily sector recovers in under two years; the second is a “lower but longer” scenario where default rates rise more slowly and peak at a lower level, but the period of peak defaults is extended and the total time to recovery is three years (Exhibit 5).
Exhibit 5: Two base case default scenarios
Note: The constant default rate (CDR) is an annualized rate of default that represents the percentage of outstanding principal balances in the pool that are in default. CDR analysis assumes that if a mortgage is in foreclosure the interest and principal payments are being advanced by the mortgage servicing company. Source: Amherst Pierpont Securities
The two base case scenarios produce different cumulative default rates of the underlying collateral over time (Exhibit 6). The first scenario (Base 1) with its sharp spike and quick recovery results in a cumulative default rate of just under 6% of the collateral over time. This is below the peak rate of 7%in the CDR scenario since the peak is brief and the default rate ramps down relatively quickly during the recovery phase. The more prolonged scenario (Base 2) peaks at a 5% CDR, but cumulatively defaults in the underlying collateral reach 8% because the recovery is slower as defaults take longer to ramp down.
Exhibit 6: Comparison of cumulative default rates of base case scenarios
Source: Amherst Pierpont Securities
The graphs of projected cumulative losses in the underlying collateral (Exhibit 7) look nearly identical to graphs of cumulative defaults because a constant loss severity rate is applied. The just below 6% cumulative default rate in base case 1 results in cumulative losses of about 2.4% (6% default rate * 40% loss severity = 2.4% losses), while the 8% cumulative default rate in base case scenario 2 results in 3.2% of projected cumulative losses (8% default rate * 40% loss severity = 3.2% losses) over time.
Exhibit 7: Projected cumulative losses (assumes loss severity of 40%)
Note: The projected cumulative losses in percent of the underlying collateral is equal to the projected cumulative defaults (%) * loss severity (%). Recovery rate(%) = 1 – loss severity rate (%). Source: Amherst Pierpont Securities
Each of these base case scenarios is “reasonable”, perhaps even aggressive, considering during the last crisis the worst performing vintages (2006 – 2008) of agency multifamily loans had cumulative losses in the range of 1.3 – 1.5%. However the performance of bonds in individual deals can vary widely from model averages. A third scenario is specifying defaults of particular loans in the pool, and the timing of those recoveries.
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