Credit unions are looking to enhance yield, while managing risks like prepayments, calls, credit, reinvestment and convexity concerns. Federal National Mortgage Association’s (FNMA) Delegated Underwriting and Servicing (DUS) bonds could be an attractive investment solution.
What is the Fannie Mae DUS program?
Launched in 1988, with securitization started in 1994, the DUS program is a popular financing option for borrowers on multifamily properties (five units or more). DUS pools are comprised of mortgages secured by multifamily properties with 30-35 year amortization terms and scheduled principal balloon at five, seven, 10 years and longer (most credit unions invest in 10 years or less).
Over 98 percent of DUS securities are single loan pool issuance, secured by first lien loans for new construction, purchases, rehabilitation or refinanced income producing properties. FNMA guarantees the bonds for timely payment of principal and interest, including monthly interest and balloon payments. In the event a loan default isn’t cured in 120 days, FNMA will pay the outstanding principal balance at par, regardless of recovery from the mortgagor. It’s important to note that FNMA has never missed a scheduled payment on any of its mortgage-backed securities, single family or multifamily mortgages.
Why consider DUS bonds for your investment portfolio?
DUS bonds are a bullet alternative to agency or corporate bullets that can provide stable cash flow with little to no extension risk, plus an attractive spread to the Interpolated Treasury curve. DUS bonds have prepayment penalties designed to protect investors and provide yield maintenance to the investment. Payments are guaranteed, and the yield maintenance provision is designed to discourage the borrower from prepaying the mortgage and to fully compensate the investors should the borrower prepay the loan.
The most common DUS bond is a 10 year balloon, with 9.5 years yield maintenance. In that six-month window, borrowers can prepay principal without penalties. To compensate, Yield Table analysis can include: yield at zero CPY (Constant Prepayment Yield), zero default throughout life and no prepayments after the maintenance period ends; and yield at 100 CPY, zero default throughout life and 100 percent prepayments after the maintenance period ends. This lock-out period allows the bond to trade similar to a bullet, and at +/- 300 basis points, the bond has comparable price movement.
In addition to prepayment penalties, another way to ensure steady cash flow is by defeasance. A less used method, defeasance is posting collateral (i.e., a Treasury security) in escrow with cash flow identical to what is prepaid. There is more to yield maintenance and defeasance, but this is a good start.
As of May 9, 2019, spreads to the Interpolated Treasury Curve were:
|
Spreads
|
Interpolated
Treasury Curve |
Yield
|
|
3 year = I/30
|
2.23%
|
2.53%
|
|
4 year = I/33
|
2.24%
|
2.57%
|
|
5 year = I/40
|
2.25%
|
2.65%
|
|
6 year = I/48
|
2.30%
|
2.78%
|
|
7 year = I/51
|
2.35%
|
2.86%
|
The current environment for multifamily housing is good. Demand is strong, occupancy rates are up, and underwriting standards are high with the 24 approved lenders that usually retain risk position in the loans. In the most common arrangement, the lender bears 33 percent and FNMA bears 66 percent of the losses. This loss sharing element provides incentive for DUS lenders to actively monitor and manage credit exposure.
Housing eligible for DUS MBS includes standard apartments (at five to several hundred units), senior housing, student housing and military housing. Apartments are the focus for most credit unions. Each mortgage is underwritten to a three-tier credit structure. Loans with higher debt-to-service-coverage ratios (DSCR) and lower loan-to-value (LTV) ratios have the most favorable rates. For example:
|
Credit Quality
|
DSCR
|
LTV
|
|
Tier 2
|
1.25
|
80
|
|
Tier 3
|
1.35
|
65
|
|
Tier 4
|
1.55
|
55
|
These investments offer many advantages to complement a portfolio of MBS, CMO and callable agencies. If your interest is piqued, Catalyst Corporate’s Brokerage Service can help you determine whether they are appropriate investments for your credit union.