Why Invest in GNMA Project Loans? 08 May 2012
08 May 2012 Weekly Market Review Treasury Yields 4.00 3.50 3.00 2.50 Yield Treasury yields were lower across the curve this past week as nonfarm payrolls failed to meet expectations yet again and trouble abroad pushed investors out of riskier assets. Nonfarm payrolls (115k vs. 160k est.) was the headline number last week as it pushed equities lower by nearly 2% and 10-year rates down 5bps shortly after its Friday release. The downward trend in job growth is even more concerning as multiple European countries have fallen back into recession and China’s growth is slowing. On a positive note, March’s nonfarm payrolls were revised up to 154k from 120k and initial claims (365k vs. 379k est.) fell to the lowest level in a month. This week’s lighter economic calendar is highlighted by PPI, U. of M. confidence and initial jobless claims. 2-year and 10-year Treasuries ended (began) the week yielding .25% (.26%) and 1.88% (1.94%), respectively. 2.00 1.50 Current 1.00 Last Week 0.50 Last Month 6mo Why Invest in GNMA Project Loans? 5 10 15 20 25 30 Maturity 20 spread (bps) Basis Points GNMA project loans are one of three categories that comprise the agency CMBS market, with the other two being FNMA DUS and FHLMC K certificates. The collateral behind GNMA project loans (20) is usually FHA guaranteed loans that are provided for the construction, purchase and refinancing of (40) Intereste Rate Change (Month over Month) multifamily homes, nursing homes, assisted living facilities and hospitals. The project loan pool consists usually of about 50 loans with each having a value of $5 million, for a total pool value of $250 million. Typically the CMO securities issued from these pools have a Chart 1: GNMA Project loans exhibited sequential pay structure that is carved into four tranches A,B,C,D with average lives of 3, 5, significantly less spread volatility during the 8, 12 years. A key feature that sets apart these securities from their single family financial crisis compared to other sectors counterparts is that they have some form of prepayment protection that lasts up to 10 years. Most loans have a 2-3 year lockout during which voluntary prepayments are strictly Historical spreads to swaps for various types of securities forbidden, but after the lockout period a prepayment penalty applies that is proportional to 700 the outstanding principle and steps down by 1% a year. For example a project loan with a 5.5Yr GNMA Project Loan 2-year hard lockout would be followed by an 8% penalty in year 3, 7% in year 4 and so on, 600 5-Yr AAA credit card ABS until the penalty declines to 0% after year 10. The standard approach when modeling 500 prepayments and pricing these securities is using the “15 CPJ” convention that assumes no 5-7 Yr AAA Corporate Financials 400 voluntary prepayments are made during the lockout period, but after the lockout ends the 300 security prepays at 15 CPR for life. In addition, involuntary prepayments (or defaults) can occur at any time and follow the GNMA Project Loan Default curve (GN PLD). The GN 200 PLD curve, which is based on historical data, uses annual default rates that range from 0% 100 to 2.51% . 0 Total Return (%) GNMA project loans are one of the few types of securities that allow investors to meet -100 specific average life requirements while at the same time providing them with cash flow Mar-04 Mar-06 Mar-08 Mar-10 Mar-12 stability. For instance, at the front end of the curve banks can invest in 3-yr GNMA CMOs Source: JP Morgan to meet their short term financial obligations, while insurance companies at the other end can invest in longer average life (i.e. 12-yr) bonds to match their longer duration liabilities. Chart 2: The GNMA project loan outperforms a In addition, due to the explicit government loan guarantee they also exhibit lower spread duration matched agency callable and bullet over a volatility compared to other securities of similar credit quality. Indeed, GNMA project wide range of parallel interest rate shifts loans exhibited significantly less spread volatility during the financial crisis compared to 5- Total returns over the next 12 months for 5.6-yr GNMA yr credit card AAA ABS and 5 to 7-yr AAA financial corporates (Chart 1). An additional project loan, 5-yr agency bullet and 7NC2 agency callable advantage of these securities is that their collateral is backed by GNMA and as a result they 15 have 0% risk capital weighting. In the current low yield environment, GNMA project loans 5-Yr agency bullet offer more yield than other securities of similar credit quality and similar duration. As an 10 5.6-Yr GNMA project loan example, GNR 2012-44 AB has a 2.6% coupon and an expected average life 5.6 years at 15CPJ. Its market price of $104-03 reflects a spread of 81bps over 5-year agencies and 7NC2 agency callable 5 10bp over 7NC2 agency callables. But more importantly, because of the prepayment protection, the project loan has a positive convexity that allows it to outperform the agency 0 callable as well as the bullet. As illustrated in Chart 2, over the next 12 months the GNMA project loan is expected to outperform on a total return basis the duration-matched agency -5 callable and bullet over a wide range of parallel interest rate shifts. Therefore, we recommend that investors consider adding GNMA project loans as they remain an -10 -200 -150 -100 -50 0 50 100 150 200 overlooked segment of the mortgage market that offers relative value opportunities. Parallel shifts (bps) Source: BMO CONTACTS Justin Hoogendoorn, CFA, Managing Director Roy Hingston, Director Dan Krieter, Associate Dimitri Delis, Ph.D, Director* Brett Adlard, Analyst * Primary author BMO Capital Markets Economic Calendar Monday 7-May Tuesday 8-May Wednesday 9-May Consumer Credit MBA Mortgage Apps 20 10 5 0 -3.8 -5 04/13 04/20 9.7 10 8.7 0 Dec Jan Feb Mar Thursday 10-May Friday Initial Claims 11-May PPI (MoM) 400 370 380 365 360 340 04/13 04/20 04/27 05/04 0.6 0.4 0.2 0.0 MBA Mortgage Refi Continuing Claims 4200 3715 3688 3900 3600 3300 04/13 04/20 04/27 05/04 3400 Uof M Confidence (P) 80 0.1 04/27 05/04 3276 3300 3280 Jan Feb 0.0 Mar Apr 73.7 75 3200 04/06 04/13 04/20 04/27 0.0 76.4 70 Feb Mar Apr May Import Price Index 1.5 1.0 0.5 0.0 -0.5 1.3 (0.2) Jan Feb Mar Apr US Trade Balance -40 -45 -50 -55 (46) (50) Dec Jan Feb Mar Monthly Budget Stmt 100 0 -100 -200 -300 30 -198 Jan Actual Feb Mar Consensus Estimate, Source: Bloomberg, Friday 5/4/12 Apr Key Economic Release Key Economic Releases Initial Jobless Claims University of Michigan Confidence (P) US Initial Jobless Claims (000), SA Univ of Michigan Confidence Survey of Present Sentiment 700 650 600 550 500 450 400 350 300 250 200 May-07 May-08 May-09 May-10 May-11 95 90 85 80 75 70 65 60 55 50 May-07 May-08 May-09 May-10 May-11 May-12 The views expressed in this report accurately reflect the analyst’s personal views. 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