By the Numbers

A total return opportunity in Freddie Mac’s WI program

| February 25, 2022

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 when-issued program for K-deals, launched last fall, looks like an interesting opportunity for total return investors. The WI certificates trade at wider spreads than traditional K classes, partly reflecting the flexibility that Freddie Mac has in determining the final pool of loans along with slow uptake so far by banks and other factors. When the WI certificates become eligible 90 days after issue for exchange into traditional K classes, the WIs should tighten to the Ks. A strategy of buying the WI at issue and selling when it becomes eligible for exchange could generate excess return in a portfolio of agency CMBS.

WI program structure

These WI certificates are issued for particular classes of K-deals up to 90 days prior to the deal being issued. Unlike traditional forward contracts, investors receive fixed monthly coupon payments guaranteed by Freddie Mac on the WI certificates before the reference deal is issued. Investors have the option of exchanging the WI certificates pro rata for the related class of K-deal pass-through securities any time after the deal settles. After settlement the class coupon of the K-deal is passed through to the WI certificates (Exhibit 1). Similar to when-issued Treasury securities, the K-deal WIs are tradeable and eligible for repo financing like regular securities.

Exhibit 1: Hypothetical WI K-deal timeline

Source: Freddie Mac When-Issued K-Deal Program Overview, page 4.

The upside of the program for Freddie Mac is that it lowers the interest rate and credit risk of warehousing the loans while the collateral pool is still being assembled. The upside for investors is that it offers a funded way to purchase K-deal certificates up to 90 days prior to deal settlement. Since the collateral is not yet identified, investors have to make decisions based on the general pool parameters defined in the offering documents. These parameters are typically somewhat broader and looser than historical average K-deals (Exhibit 2).

Exhibit 2: Typical pool parameters

Note: 1 The typical pool parameters for any particular deal may differ from the pool parameters outlined above. 2 Future collateral characteristics may differ from historical averages.
Source: Freddie Mac When-Issued K-Deal Program Overview, page 7.

The slightly wider range of collateral specifications and flexibility of the deal issuance window have contributed to a widening of spreads at pricing of the WIs versus the standard K-deal securities (Exhibit 3).  The initial launch of the program in September seemed to be reasonably well digested, with the first WI K132 AM class pricing at 27 bp over swaps, just 1 bp back of the FHMS K131 AM issued two weeks before. Three WI AM classes for K133, K134 and K135 deals all priced at 25 bp over swaps in October.

Exhibit 3: Spreads at pricing of standard and WI classes of 10-year, fixed-rate K-deals

Note: As of December 2021 most classes of K-deals began to be priced off the SOFR swaps curve using P-spreads. These P-spreads have been converted to spreads versus the LIBOR swaps curve (N-spreads). Data through 2/16/2022.
Source: Bloomberg, Amherst Pierpont Securities

As spreads began to widen in November, the WI AM classes began to price wide of 10/9.5 DUS (Exhibit 4). Initially, the spread between FHMS A2s and DUS remained fairly stable with 10/9.5 pricing 5 bp to 7 bp back. That changed in late January when the WI program expanded to include the A2 class. The first WI A2 to price was the WI K140 A2 which came at LIBOR swaps + 35 bp on January 26 this year. The WI K140 AM priced at the same time at LIBOR swaps + 44 bp, or 9 bp back of the WI A2. Through late January into mid-February, spreads continued to widen and DUS 10/9.5 were pricing in-line with the WI A2s and inside of the WI AMs.

Exhibit 4: Pricing spread of Freddie Ks compared to Fannie Mae DUS

Source: Bloomberg, Amherst Pierpont Securities

Multiple factors could be contributing to the additional pressure on WI Ks:

  • As the market sold off many investors have pulled away from longer duration securities, particularly bank and insurance companies with mortgage portfolios that are extending.
  • Banks, who have traditionally been among the heaviest investors in A2s, have often faced additional hurdles to get approval to buy and trade the WI certificates.
  • Other portfolios are limited to securities with durations under 10 years. The WI AMs typically have an assumed weighted average life of 10.25 years at pricing, which would make them ineligible investments.
  • To complicate things further, K-deals began pricing off of the SOFR swaps curve in 2022 using P-spreads, as opposed to off of the LIBOR swaps curve using N-spreads. It’s simple to make the conversion, but it does add another wrinkle into a newly introduced product in a volatile market.

Money managers have stepped in as the largest buyers of some of the first WI AM classes of K-deals (Exhibit 5). It isn’t clear yet how much trading of the WIs is occurring prior to deal settlement, but it seems probable that some investors intend to capture the additional premium of the WIs and sell them after the WI certificates are eligible to be exchanged for securities. Tightening of only a few basis points on an instrument with a spread duration of more than nine years can quickly add up, and the regular cycle of WI issuance could give a total return portfolio a steady set of opportunities to recycle the trade

Exhibit 5: Breakdown of investors for WI K135 class AM (priced October 26, 2021)

Note: The breakdown of the investors is as of the closing date.
Source: Freddie Mac When-Issued K-Deal Program Overview, page 9.

Complete program details can be found in this WI investor presentation and WI FAQ, published by Freddie Mac.

Mary Beth Fisher, PhD
marybeth.fisher@santander.us
1 (646) 776-7872

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