Multifamily MBS can serve core portfolio needs

Two thousand eighteen could be the year of the big investment portfolio shake-out. In particular, with industry earnings poised to jump this year, there could well be a big increase in demand for tax-free securities. The only problem is state and local governments aren't cooperating by stepping up their borrowing; in fact, for the first two months of 2018, new issuance was 38 percent behind the same period last year. This supply/demand mismatch helps explain why muni prices have fallen a lot less than benchmark Treasuries have this year. 

Faced with limited options about what to buy on the longer end of the duration scale, more and more community banks are investing in a product that has some similar characteristics to the mortgage-backed securities (MBSs) most already own: Fannie Mae and Freddie Mac multifamily securities. We'll examine how these work, and why they appeal to many investors. 

Adequate Supplies

Community bankers are getting around to liking the MBSs that are backed by multifamily loans. That sector, like the loans that act as collateral, has seen remarkable growth in the last five years. As the product depth has grown, so has the liquidity of the securities. In 2017, both Fannie Mae and Freddie Mac had record volumes of multifamily MBS issuances which in aggregate were about 9 percent of all new issues. 

They have similarities to the generic single-family MBSs, but are not identical. Many community bankers buy the multifamily story for no other reason than diversification. Like all other Fannie/Freddie securities, these have 20 percent risk weighting, have guaranteed timely payment of principal and interest, and are generally pledgeable. The credit quality on these products is very good, with very low delinquency rates.

DUS Bonds

Fannie Mae delegated underwriting and servicing (DUS) securities comprise the largest segment of the multifamily sector. These usually are collateralized by a single loan on a large development, so the pool size can range from $1 million to $50 million. They have fixed rates with balloon dates in generally 10 years, so the average life at the outset is around nine years. 

As DUS bonds are fixed rate and can trade at premiums, a risk-averse portfolio manager should immediately wonder how the prepayment risk is alleviated on a single loan pool. The answer is a prepay penalty structured as a "yield maintenance" payment that makes it extremely unlikely for an early voluntary prepayment to occur. 

The cash flows from DUS bonds are very little until balloon date, owing to the 30-year amortization period. It is possible to find seasoned issues, so a buyer can target a specific average life or maturity date. 

Freddie K/Fannie ACES

Alternatives to the DUS bonds are the Freddie Mac "K" and Fannie Mae "ACES" programs. These securities are backed by pools of multifamily loans instead of a single credit. The pools can be quite large; the typical deal size is over $1 billion. These are also "structured" pools, with multiple tranches of varying seniority to cash flows and prepay risk.

These too are fixed rate and can have long average lives, but shorter tranches are available. Another benefit (in the mind of the typical community banker) is that certain classes can have "current coupons," meaning they can be purchased at prices very close to par. Therefore prepayment risk, which is very low to begin with, can be essentially eliminated. 

Prepayments are also very low for both of these products. The reason prepayments are very infrequent on Freddie K's is that several forms of prepayment protection are in place. The two most common are yield maintenance and "defeasance." In either case, the investor is virtually assured of receiving the expected yield and cash flows. For Fannie ACES, which are actually pools of DUS bonds, the same yield maintenance provisions discussed above are in place.

Check Them Out

There are a few more positives to consider. While multifamily MBS's have become more prominent recently, they still in aggregate are a relatively small component of the entire mortgage market. In spite of this, their liquidity is very good, and compares very favorably with standard pass-through MBSs. 

Also, the cash flows in either product are back-loaded, so there is little reinvestment income initially. These may be suitable alternatives to munis in that they can form the long end of a barbell portfolio structure. And with longer rates at their highest levels in at least five years, you may be pleased to find their yields are comparable to munis, given lower marginal tax rates. Multifamily MBSs could provide a safe long-term parking lot for some of your community bank's core investment dollars.

Reber is president and CEO of ICBA Securities, a WBA Gold Associate Member. He can be reached at 800-422-6442 or jreber@icbasecurities.com. ICBA Securities' exclusive broker Vining Sparks has a number of research reports and inventory positions for Fannie Mae and Freddie Mac multifamily bonds. To learn more, contact your Vining Sparks sales rep or visit www.viningsparks.com.