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Ratings transitions in Freddie K deals
admin | August 9, 2019
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.
Strong price appreciation in multifamily properties coupled with increased incentives to refinance at lower rates has pushed defeasance levels in Freddie K deals to all-time highs. Ratings on seasoned B and C classes have climbed as a greater percentage of the underlying commercial mortgage loans are replaced with Treasury securities, enhancing credit support. Defeasance levels are expected to continue to trend higher in the near term. The prepay protection and potential for upward ratings migration has made Freddie B and C classes an attractive alternative to residential MBS and BBB-rated corporate debt.
The building refinance tsunami
Prepay speeds on 30-year mortgages picked up more than 30% in July when the 10-year Treasury yield was still above 2.00% and 36% of outstanding conventional 30-year mortgages were in-the-money to be refinanced. The latest rally in Treasury rates has pushed approximately 50% of these mortgages into the refinance window (Exhibit 1), and speeds are expected to surge higher. A complete discussion is in the APS prepayment report, here.
Exhibit 1: % of MBS that are in-the-money for various 10-year Treasury rates
Note: A mortgage loan is considered to be in-the-money when its coupon is 75 bp above the current Freddie Mac Primary Mortgage Market Survey rate. Source: Fannie Mae, Freddie Mac, eMBS, Amherst Pierpont Securities
Banks and insurers appear to be avoiding some of the negative convexity risk by migrating towards agency CMBS, using Freddie K deal A and AM pieces as a replacement for agency MBS, and as an alternative to corporate AAA to AA-rated paper, which tends to be substantially less liquid. For a complete discussion, see the APS piece, Banks become negative on negative convexity.
Investors willing to go down in credit and forgo the agency guarantee can consider the B and C classes of Freddie Mac K deals. Commercial mortgage loans in Freddie K deals are locked out from prepaying until they have only 6 months remaining to maturity. Borrowers who wish to prepay their loans in order to refinance or sell the property must defease the loan with Treasury securities. These B and C classes have a variety of ratings from BB to AAA, and tend to migrate upwards in the ratings as they season, because a greater proportion of the loans are defeased with Treasury’s over time. This can be seen in the ratings transition matrix which covers most of the universe of Freddie K B and C classes.
Defeasance rises on multifamily strength
Strong performance across the multifamily housing sector has resulted in all-time high levels of defeasance in Freddie K-deals, and a new trough in the amount of supplemental financing, according to a report by Kroll Bond Rating Agency (KBRA). Multifamily price growth was 2.1% in 1Q 19 and 8.5% for the trailing twelve month period. That’s after an 11.3% increase for the trailing twelve month period in March 2018, according to data from CoStar Group. The unpaid principal balance that has been defeased in Freddie K-deals rose 86% year-over-year to $3.86 billion, an all-time high. The defeasances contributed to eight upgrades on Freddie K-deals rated by KBRA. The amount of supplemental debt taken out by borrowers fell 36% to $254 million. It’s unclear whether the drop in supplemental debt is due to caution on the part of borrowers or Freddie Mac. Defeasances are expected to keep rising over the near term based on continued price appreciation of multifamily properties and strong incentives to refinance, meaning ratings upgrades of Freddie B and C classes are likely to continue.
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