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Forbearance risk varies by class in FRESB deals
admin | July 31, 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.
Freddie Mac’s multifamily borrowers in their small balance loan program have experienced greater stress due to the economic disruption from the pandemic than those borrowers with loans in standard K-series. FRESB deals on average have a greater proportion of loans in forbearance than standard K-series, but the potential impact on investors is more difficult to evaluate. The sequential paydown structure of typical K-deals tend to concentrate the risk from involuntary prepayments in the A1 classes. FRESB collateral is tranched based on the underlying loan structure, making the distribution of forbearance risk across classes unpredictable. The result is that in a deal with 20% of the loan balance in forbearance, some classes have low or zero exposure, while other classes in the same deal have 50% or more of the outstanding balance currently in forbearance.
Exhibit 1: Concentration of forbearance risk by class in FRESB deals
Note: Table shows risk distribution for FRESB deals with 10% or more of the overall deal balance in forbearance. Classes where the percentage is blank either have zero forbearance risk, are not present in that deal, or have already paid down. Data as of 7/31/2020. Source: Bloomberg, Freddie Mac, Amherst Pierpont Securities.
Investors that own FRESB classes with high concentrations of loans in forbearance are at risk of accelerated involuntary prepayments should some of those loans transition into default. The classes shown above are all guaranteed by Freddie Mac, of course, so the issue is primarily one of potential underperformance of the class due to the prepayments, which is exacerbated for high premium dollar price classes.
Owners of typical subordinate classes of FRESB deals, the B-piece investors, have exposure to the entire pool of collateral, similar to the subordinate investors in K-deals. Though they absorb the first losses, their risk is actually more diversified than that of the guaranteed classes which are based on subsets of the loans. Evaluating that risk is more time intensive, since it requires reviewing every loan in the pool.
Projecting which loans are likely to migrate into default versus those that are likely to cure is especially difficult. Financials are usually only updated quarterly, so information on most loans will begin trickling in next month for 2Q 2020. Some loans appear to have had their financials updated when they entered forbearance, though that is not consistent. For example, some loans in forbearance have debt service coverage ratios below 1.0, which is a clear indicator of financial stress, while others have DSCRs above 2.0 (Exhibit 2) based on the available data.
Exhibit 2: Aggregate financials of Freddie Mac multifamily loans in forbearance
Source: Bloomberg, Amherst Pierpont Securities
Although loans in K-deals are larger and the properties have many more units on average, from a broad overview the financials do not look significantly different, with similar DSCRs, LTVs and occupancy rates.
As financials are updated it will be possible to stratify loans based on “COVID-impacted” data and make projections of what loans in forbearance appear to be under significant stress versus which borrowers may have requested a forbearance based on an abundance of caution. For now, investors with FRESB bonds that are overweight loans in forbearance may want to begin a deeper analysis of those loans to get a sense of how strong the financials were prior to COVID and how much cushion the borrowers may have to weather the short term cash crunch.
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