Many people outside of the public finance community are unaware that state and local housing finance agencies issue municipal bonds to finance affordable single- and multi-family programs. Often referred to as housing revenue bonds (HRBs) or mortgage revenue bonds (MRBs), these bonds are backed by a pool of single-family mortgage loans, multi-family loans or a combination of both.
The structures and nuances of these bond types can be complex with added risk considerations and they generally guide ratings assignments and secondary market performance, pricing and liquidity. However, with operational understanding, MRBs can offer a source of portfolio diversification that provides yield and income opportunities.
Taxable housing bonds can be used as a way to navigate around IRS programmatic rules and other requirements for tax-exemption, avoid private-activity volume cap constraints and provide flexible refinancing options for outstanding debt. Various issuers use a hybrid structure incorporating taxable bonds in support of non-qualified loans. While taxable MRB funded loans generally carry higher mortgage rates than those offered by tax-exempt counterparts, program subsidies, other forms of assistance and structural guarantees can preserve competitive standing for these loan types.
Municipal advisors, along with investment bankers and bond attorneys, actively advise their MRB issuer clients on the best way to leverage existing ratings, adhere to best disclosure practices and structure their transactions in a manner that will optimize cash flows and safeguard the integrity of the debt service waterfall.
While single-family MRB programs originate loans to first-time homebuyers meeting certain income and purchase price criteria, multi-family mortgage loans finance the construction or rehabilitation of multi-family housing projects adhering to their own income set-aside requirements. Stringent low-income provisions for affordable multi-family housing along with other developer disincentives were imposed on the market as far back as the 1986 Tax Reform Act. Importantly, HFAs do not finance sub-prime loans.
It is important to understand the differences between state housing finance agencies and local housing finance agencies. State HFAs are state chartered agencies created to meet the affordable housing needs of low-to moderate-income residents in the 50 states, the District of Columbia, Puerto Rico and the Virgin Islands.
State HFAs are independent, quasi-governmental entities created by state statute with a board of directors appointed by the governor, legislature or a combination of the two. They are characterized by ongoing fiscal management, well-defined operating guidelines and an accumulation of substantial fund balances that are often pledged for debt repayment. Generally, MRBs are a general obligation of the agency secured by a pledge of unrestricted assets, with a pledge of specific assets often part of the legal structure. Certain financings may be a special obligation of the agency, secured only by pledged assets of the loan program. Importantly, not all state HFAs are created equal. Programmatic differences exist state to state with variable size, scale, and depth of service offerings, and investors should not assume common practices across this issuer cohort.
Under an open indenture, additional parity bonds can be issued, while a closed indenture represents a stand-alone portfolio, usually created for local agencies. Reserve funds under the bond resolution typically include: 1) a debt service reserve fund, funded at the annual debt service level or by a percentage of bonds or loans outstanding; 2) a mortgage reserve fund, typically a percentage of loans outstanding. When analyzing MRBs, profitability levels, program fund balances and a program asset-to-debt ratio are closely monitored against bond covenants.
An executive director (or equivalent role) leads overall strategy and staff management, oversees capital market engagement, and promotes and defines relationships with program stakeholders. such as lenders, underwriters, municipal advisors, bond lawyers, policymakers, developers and investors.
These agencies maintain a dedicated finance director/CFO leading a team of finance specialists. They tend to have flexible balance sheets and the strongest issuers are defined by well-seasoned and proven parity indentures, ample levels of overcollateralization through program reserve funds, significantly lower delinquency and foreclosure rates and prime quality ratings across the AAA and AA categories. State HFAs adhere to formal and comprehensive practices surrounding loan qualification, underwriting, approval, servicing and monitoring.
Although state HFAs access the muni market with different regularity, investors are drawn to diversified geographic dispersion, sound disclosure practices, a predictable and transparent waterfall, conservative program attributes, societal benefits and a commitment to capital preservation. While state HFAs are not tax supported, many programs are enhanced by state make-up provisions for debt service reserve funds or moral obligation pledges.
The National Council of State Housing Agencies (NCSHA) is a nonprofit, nonpartisan organization created by U.S. state housing finance agencies more than 50 years ago. The mission of the NCSHA is to advocate on behalf of state HFAs and articulate their priorities to Congress and various federal agencies. The NCSHA supports education, training and best practices for agency staff and promotes HFA leadership and innovation in addressing state housing needs.
According to the NCSHA, state "HFAs have delivered more than $800 billion in financing to make possible the purchase, development, and rehabilitation of more than 8.2 million affordable homes and rental apartments for low and middle income households. Every year, these agencies help 250,000-275,000 owners and renters all across the country."
State HFAs have made homeownership more affordable for 4.4 million lower-income homeowners and homebuyers by financing affordable mortgages, providing down payment assistance, supporting affordable home construction, and funding essential home improvements. State HFAs have provided lower-cost homes and improved housing conditions by financing more than 3.8 million apartments for low-income renters through apartment development, allocating construction incentives, delivering rental assistance and ensuring quality property standards and timely rent collection.
State HFAs were disclosure pioneers and were the first issuer group to develop and begin using a standardized format for secondary market reporting. Dating back to 1988, NCSHA's Disclosure Task Force, with the assistance of the National Federation of Municipal Analysts, Moody's Investors Service, Standard & Poor's Corp. and other market participants, developed the single-family mortgage revenue bond disclosure format.
The format was adopted by NCSHA membership in 1989. The NCSHA disclosure guidelines suggested the submission of information on a quarterly basis. Interested parties who required specific knowledge of an issue's operating performance or who needed to evaluate the likelihood of an early par call welcomed the new developments. A separate multi-family reporting format was subsequently approved.
Prior to the implementation of the NCSHA guidelines, no issuer group submitted quarterly secondary market financial data on individual outstanding bond issues. At that time, state HFAs only prepared some form of audited annual financial statements, which lacked standardization and did not account for specific bond programs.
Various institutional investors who were active housing bond buyers strongly urged HFA issuers to adopt the NCSHA disclosure guidelines, setting the stage for today's disclosure standards in the MRB space. Evaluation of loan performance is particularly relevant with MRBs trading in the secondary market at premium levels.
While I like the structure of the HFA programs, I am mindful of certain inherent challenges and weaknesses. Single-family MRB issuance patterns are heavily guided by conventional mortgage rate levels as subsidized interest rates on newly originated MRB mortgage loans — thanks to the associated tax-exemption on the bonds — are below current market mortgage rates.
A protracted period of low interest rate mortgages could depress MRB issuance. During these times, HFAs find it difficult to issue tax-exempt bonds and offer mortgage loans with rates low enough to compete with conventional market rates. Federal arbitrage rules limit the spread between the mortgage loan yield and the bond yield.
Single-family MRBs normally have extraordinary par call exposure (ERP) which limits their market price appreciation. Typically, these calls are triggered by unexpended bond proceeds, mortgage prepayments, excess revenues or a combination of the three. The presence of a supersinker (heavily targeted single maturity accelerated amortization) or PAC bonds (planned amortization to smooth average life) are used by issuers for prepayment risk management and cash-flow purposes and are carefully assessed for their callability.
Another call provision, perhaps more obscure today, involves an issuer's authority to cross-call. This is the ability to utilize mortgage prepayments and/or excess revenues generated by one or more bond issues to redeem bonds from another of the issuer's deals at par.
Under a cross-call scenario, the issues must be part of a parity indenture that provides the legal authority to cross-call. Unexpended proceeds are typically issue-specific, therefore, this revenue source would not be utilized for cross-calls. While cross-calls are normally done in order to retire an issuer's highest coupon debt, actual implementation is routinely subject to cash-flow analysis. Over the years, more targeted recycling provisions for new loan originations, adherence to stringent tax laws and transparency concerns have significantly limited cross-call capacity and much of this activity is confined to legacy indentures.
These provisions often make redemption analysis — rather than credit analysis — a key valuation and investment driver. Due to the inherent par call exposure, investors can pick up extra yield given the limited price appreciation in a declining interest rate environment.
These calls tend to have a greater impact on single-family MRBs than on multi-family structures. Multi-family MRBs are relatively less susceptible to par calls because there is usually less risk of miscalculating loan demand. Furthermore, multi-family bond programs are bound by certain bond prepayment rules during the first 10 years of the loan. Unexpended bond proceeds and prepayment redemptions generally have greater impact and are normally done during periods of declining mortgage rates, when the competitive advantage is removed from program rates.
During a single-family program's origination period (usually three years), a bond issue can be subject to an unexpended proceeds call at any time or on any interest payment date at par for current interest bonds and at the current compound accreted value for capital appreciation bonds. Mortgage prepayments can also trigger an early par call, as conventional rates decline to a level that makes refinancing attractive to a subsidized program homeowner.
Prepayment call exposure for single-family issues exists for the life of the bond. Single-family MRBs are less prone to early par calls during periods of low mortgage rates versus bonds sold in higher rate days, where they experience heavy extraordinary redemption and refinancing activity. MRBs issued with relatively low program mortgage rates should prove desirable over time. For these structures, ERPs would be more modest and the bonds would likely have longer average lives and more continuity of tax-exempt income.
Premium priced single-family MRBs that trade in the secondary market would carry the most market risk from an early par call. Reinvestment risk may exist, as monies received from an ERP may have to be reinvested at lower yields than on the original investment. This is why it is advisable to determine whether the mortgage origination period has expired and all loan proceeds have been expended. A mortgage recycling feature for origination of new loans may reduce early redemption experience, thus making the investment more attractive. Call priorities from prepayments and excess revenues can add call protection for certain bond maturities.
Policy and affordability issues also weigh heavily on supply considerations. Multi-family programs are viewed as less rate sensitive, but policy and affordability factors also frame their overall issuance activity. Both bond types are subject to the vagaries of state private-activity bond volume caps.
A decline in the creditworthiness of private mortgage insurers could also undermine program viability. Reserve funds and timely management response could offset this concern, although I would note that substitution of a PMI provider is not an immediate option. Economic displacement and the effects on the housing market — and elevated delinquencies and foreclosures due to high unemployment rates — could also impact issuance and program integrity.
Credit market factors may be more impactful upon MRBs, particularly if liquidity conditions are constrained. Although certain federal government programs provide, or have provided, liquidity support for these financings, there remains limited liquidity renewal risk. While most HFA issuance is fixed-rate — to match long-duration mortgage assets, better align prepayment activity with bond structure, and meet rising SMA buyer needs — issuers do employ variable rate demand notes (VRDNs) and tender option bonds.
These short-term vehicles may be used for certain ARM programs or multifamily bridge financing. The risk may be that the liquidity provider — usually a bank — is unable to remarket the securities through a letter of credit (LOC) or a standby bond purchase agreement (SBPA).
This does not represent fundamental issuer credit risk, as short-term remarketing risk is shifted to a financial institution.
Although such risk is relatively low, there are periods of heightened bank uncertainty that could undermine market efficiency (let's recall Silicon Valley Bank). Alternatively, in certain situations, an HFA could use a self-liquidity facility as opposed to securing a bank commitment.
Local housing finance agencies issue tax-exempt and taxable bonds to finance affordable single- and multi-family programs to meet the needs of their communities. Most are conduit issuers with the exception of some very large and prolific entities, such as New York City Housing Authority, which have many of the structural elements described for state HFAs. Most local HFA programs are stand-alone, with the mortgages fully enhanced by the U.S. government or through other forms of credit support. This credit structure often enables local HFAs to secure investment-grade ratings.
There are very distinct differences between state HFAs and RMBS structures which highlight programmatic benefits of owning HFAs. While RMBS securitized loans can be fixed- or adjustable- rate, with a variety of terms and can include jumbo and subprime loans in the pool, most HFA loans are fully amortizing, 30-year fixed-rate level payment mortgages. HFAs do not include subprime loans and bullet maturities. HFA loan pools contain a diversified mix of seasoned and new loans, while RMBS loan pools are generally static.
State HFAs generally underwrite to more conservative standards including FNMA, FHA or VA, while RMBS underwrite to more variable standards. RMBS structures typically incorporate pass-throughs with multiple tranches of debt, but state HFAs usually use senior serial or term maturities with very little application of tranches.
As mentioned, state HFAs require first-time home buyers to meet specific criteria, while there are no similar restrictions for RMBS. Although state HFAs have stringent mortgage insurance requirements for loans having less than a 20% downpayment, RMBS have more relaxed mortgage insurance guidelines. State HFAs possess a comprehensive oversight process, while RMBS loans are sold following origination.
Structural complexities of MRBs can often produce yield opportunities, but also rationalize a risk premium and difficulty in modeling cash flows. Multi-layered credit enhancements, nuanced program rules, unique redemption features, policy shifts, evolving housing market conditions, and regulatory changes require careful review and analysis. These bonds tend to show more liquidity constraints during periods of market turmoil and stress, with a more visible widening of bid-ask spreads. Quotes tend to be more indicative rather than firm.
Against this backdrop, MRBs represent an essential purpose investment that greatly helps to address the growing housing affordability crisis in the U.S. Investment in these securities requires more than just a casual understanding of the above-mentioned factors. For those willing to put in the time, state agency MRBs can be part of a conservative sleeve of assets that offer value, cash flow and credit quality.
