The swift prepayment speeds in Freddie Mac K-Series floating-rate loans
admin | April 9, 2021
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.
The rising issuance of Freddie Mac floating-rate CMBS backed by floating-rate loans has revived interest in prepayment speeds. In short, they are much faster than speeds in fixed-rate loans and likely leave the average life of the floating-rate CMBS much shorter. This should be welcome news for banks on the hunt for assets with low duration and steady cash flow liquidity.
The basics of prepayment speeds in floating-rate K-Series loans are straightforward:
- After a 1-year lockout period, the floating rate loans are prepayable with a 1% penalty. The prepayment penalty goes to Freddie, not to the investors
- Prepayment speeds begin to rise immediately after expiration of the lockout, hitting 27 CPR on average two years after origination and rising to 40 CPR and then 50 CPR in years three and four (Exhibit 1)
- Involuntary prepayments do happen but have been relatively rare in Freddie K floaters since a cluster of defaults from the 2012 vintage (which occurred in 2019)
Exhibit 1: FHMS K-F Floater: Prepayment speed ramp by loan vintage – CPR (voluntary and involuntary)
Source: Intex, Amherst Pierpont Securities
- The average life of a new floater at 0 CPY is 9.4 years. This can be seen by running the SOFR floater, the FHMS K-104 AS, issued in March 2021 in Bloomberg’s SYT screen. However, running it at a steady 25 CPR, which is the lifetime average prepayment speed for K-Series floaters shown in the table, the average life drops to 3.9 years. Running the historical prepay vector of speeds shown in the last row of the table above reduces the projected average life to 3.6 years. Even at 50% of the historical speed vector, the average life drops to 5.3 years.
- The 1% prepayment penalty can be waived if the borrower refinances into a Freddie Mac fixed-rate loan. On average 25% of floating rate K loans that prepay over time have their prepayment premium waived (Exhibit 2).
Exhibit 2: FHMS K-F Floater: Prepayment speed ramp by loan vintage – % prepayment premiums waived
Source: Intex, Amherst Pierpont Securities
- Generally speaking, prepayment in floating-rate loans tend to slow down when the curve steepens and accelerate as the curve flattens. The chart below is a scatterplot of monthly average CPR of Freddie’s floating rate loans against the 2s10s Treasury slope at the beginning of the month (Exhibit 3). It does not account for burnout of many loans or the time it takes to refinance, which is longer than a couple of weeks, but it does illustrate the point that refis of floating-rate loans are sensitive to curve shape – as fixed rates approach the floating rate, borrowers tend to refinance more quickly. A steep curve slows down prepayment rates of floaters.
Source: Amherst Pierpont Securities
The average life of the K-Series floating rate debt is a key part of current relative value. Comparing a K-Series AS class to a K-Series fixed-rate A2 class with a 10-year weighted average life requires weighing a current AS coupon of 26.1 bp to an A2 swapped to floating of 29 bp. The AS has a floor on the coupon and less operational and accounting complexity. The shorter average life adds to the appeal of the AS, making the relative value case for the K-Series SOFR floaters stronger.
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