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Minnesota Housing Readies 3rd Use of Pass-Through MBS Structure

JAN 8, 2013 2:36pm ET
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CHICAGO — The Minnesota Housing Finance Agency hits the market Wednesday with $75 million of tax-exempt homeownership finance bonds that mark its third use of a mortgage-backed pass-through structure that’s helped jumpstart new-money, tax-exempt borrowing for single-family housing.

The housing agency first used the structure crafted by RBC Capital Markets in late July, and is now on its third tranche due to its success, said MHFA chief financial officer Don Wyszynski.

The agency could not generate the income needed to fund program loans using a traditional housing structure, in which HFAs use proceeds of their tax-exempt issuance to purchase a package of MBS backed by the guarantee of a federal government agency or a government sponsored enterprise.

“Taxable mortgage-backed securities were selling at lower yields than we could sell traditional tax-exempt bonds, so we were definitely looking for a new structure,” Wyszynski said.

The structure crafted for the agency by RBC taps into the universe of traditional buyers of MBS backed by the Government National Mortgage Association (Ginnie Mae), the Federal National Mortgage Association (Fannie Mae), or the Federal Home Loan Mortgage Corp. (Freddie Mac).

Buyers are looking for supply amid the Federal Reserve’s ongoing purchases of $40 billion of MBS monthly, which have helped keep interest rates so low.

Under the pass-through structure, MHFA will issue tax-exempt bonds marketed to MBS buyers with a 30-year bullet maturity that pays a significantly lower yield in the current market than a traditional housing bond.

The agency will use the proceeds to purchase a package of mortgage-backed securities. Income generated from the spread allows the authority to offer competitive mortgage rates for first-time single-family low to moderate-income home buyers. The loan portfolio will be comprised of securities pooled by the authority and guaranteed by Ginnie Mae, Fannie Mae and-or Freddie Mac regardless of performance of the underlying mortgages.

Moody’s Investors Service assigned a AAA rating and negative outlook on the bonds based on the U.S. government’s rating. The rating reflects “the high-quality collateral comprised of GNMA and Fannie Mae mortgage-backed securities, as well as the 1.024 times program asset-to-debt ratio,” Moody’s wrote.

The bonds are also backed by the finance authority’s general obligation pledge, which carries a Aa1 rating from Moody’s.

RBC is the senior manager. Morgan Stanley and Piper Jaffray & Co. are co-managers. Kutak Rock LLP is bond counsel and Dorsey & Whitney LLP is underwriters’ counsel.

CSG Advisors Inc. served as advisor to the authority and helped craft the structure.

The Minnesota agency debuted the structure last July on a $50 million deal. That issue marked the first public offering by a housing finance authority of a tax-exempt bond using a mortgage-backed pass-through structure.

“The pass-through bond program sold for Minnesota Housing represents a breakthrough structure which substantially reduces the cost of tax-exempt financing and will allow tax-exempt bonds to once again be a viable funding alternative for state HFA lending programs … based on accessing an entirely new class of investors,” RBC said in an overview of the program prepared for the July sale.

RBC has worked with several other housing agencies since then, including ones in Illinois, Iowa and New Mexico, tapping the same structure to sell either taxable or tax-exempt bonds.

“We have taken a traditional 30-year housing bond with semiannual principal and interest payments and turned it into a monthly pay, pass-through bond,” said RBC housing sector banker Cory Hoeppner, a managing director, who helped craft the bank’s program.

As the underlying mortgages are repaid, all of the principal received is passed through to the investor to ensure parity between the bonds and the MBS, hence the direct pass-through designation. MBS are commonly referred to as “pass-through” certificates because the principal and interest of the underlying loans is passed through to investors.

Unlike most other pass-through structures, the Minnesota agency’s bonds are publicly offered with a 10-year par call found in traditional housing bond issues. Variations of a pass-through structure have been offered as private placements with Fannie Mae, but the July issue marked the first public offering. Other banks are now pitching variations of the structure. 

Early last year, RBC began looking at how it could tinker with the MBS structure and tax-exempt features to suit HFAs, according to Hoeppner.

The structure it settled on isolates cash flow to win over traditional MBS investors. The firm identified a class of traditional investors who purchase MBSs in the TBA (to be announced) market and offered up the agency’s new securities as an alternative investment with an added benefit of being sold at par, and not at a premium.

RBC initially sought out traditional tax-exempt buyers of single-family bonds but they ultimately rejected the securities because of low yields.

“This bond has a number of attractive characteristics, including the ability to purchase at par, which isolates investors from price and yield fluctuations resulting from prepayments, a defined MBS portfolio that can be easily modeled by investors and tracked on Bloomberg, isolation from traditional cross-calling of bonds within the indenture, and, of course, tax-exempt income, which is not available to traditional MBS buyers,” RBC said in its written overview.

The firm received orders from 12 investors totaling about $200 million on the July sale and the issue captured a rate of 2.60%. The yield for a traditional single-family issue based on market rates that week was at 3.31%, a 70 basis point difference.

Without the success of the new structure, Wyszynski said the agency would have been forced to directly sell MBSs in the TBA market as other housing agencies have done.

That avenue is less efficient, he said, because all of the agency’s profits are taken upfront and HFAs prefer a financing model with smoothed income that flows in over time.

“We have been very happy with structure and will use it as long as it works,” Wyszynski said. “We are able to get an interest rate that allows us to still charge a below-market interest rate on loans.”

The Minnesota agency followed up its July sale with a $75 million issue in October. That deal priced at 2.25%. On the second transaction the underlying MBS portfolio included up to 25% Fannie Mae securities.

RBC’s sales and trading staff market the product to a few dozen buyers, including banks, insurers and other asset managers, Hoeppner said.

Traditional single-family mortgage revenue bonds use semiannual serial and term bond structures or planned amortization- class bonds.

Their interest rates traditionally tracked lower in yield than conventional mortgage rates, which allowed the nation’s housing finance authorities to finance their lending programs at competitive rates.

That changed after the 2008 financial crisis when conventional mortgage rates continued to fall, and the Federal Reserve Board’s monetary policy aimed at keeping interest rates low and its ample purchases of mortgage-backed securities have kept conventional mortgage interest rates at record lows.

As Treasury rates fell and tax-exempt bond rates stabilized at a level higher than conventional mortgage rates, traditional single-family structures no longer could generate sufficient income for HFAs to offer competitive loan program rates. Variable-rate structures haven’t offered a solution in recent years because of skyrocketing costs for liquidity support.

In late 2009, the housing finance market received help with the Treasury Department’s creation of the New Issue Bond Program, in which the Treasury agreed to buy $15.3 billion of securities from Fannie Mae and Freddie Mac that were backed by new mortgage revenue bonds or multifamily housing bonds issued by the HFAs.

Forty-seven local HFAs participated in the NIBP. The program expired at the end of last year, although many issuers had already exhausted their program capacity before the end of the year.

Single-family bond issuance has generally been limited of late to refundings, market participants say.

Hoeppner, a veteran housing banker, said he began exploring how to create a pass-through structure for HFAs early last year with RBC’s sales force and underwriting desks. The process has involved a good amount of marketing and investor education.

A central issue to attracting MBS buyers was creating a structure that had most of the features — from the collateral backing to the bond to the monthly pay feature — they were accustomed to buying in the TBA and secondary markets while also suiting the HFA’s needs.

“We tried to make this look as vanilla as possible,” Hoeppner said. The HFA offerings provide competitive yields on a par basis relative to the high premiums investors are seeing in the traditional MBS market.

Most also offer the benefit of tax-exemption. While the buyers are not traditional municipal buyers, some institutions can make use of the tax-exempt status, so many HFAs have continued to tap their private-activity volume cap to pare down yields.

While the structure currently works to HFAs’ advantage, that could change depending on interest-rate movement, mortgage rates and future Federal Reserve monetary policy decisions, although it has said its current policy is likely to remain in place until unemployment comes down.

Due to tax restrictions, some of the transactions led by RBC using the pass-through structure have offered taxable securities. Iowa offered two deals late last year, one taxable and one tax-exempt. The taxable deal sold at a 2.30% yield while the tax-exempt deal paid 2.15%.

“Based on positive investor demand, we expect the market to deepen and spreads to narrow both as more investors become educated as to the benefits of the structure and as liquidity in the market for these bonds increases,” RBC said in its overview.

The Illinois Housing Development Authority late last year issued $41 million of taxable single-family bonds using the structure. It captured a 2.63% interest rate.

In a statement, the IHDA praised the structure and savings and said the purchasers of the bonds included banks, money managers and insurance companies that were not traditional municipal housing bond investors, allowing the authority to forge new partnerships.

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