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January 17, 2020  

Housing Action Affects Agency Bonds

A municipal authority’s move to preserve affordable housing in the Seattle area by acquiring properties via eminent domain has raised new concerns for holders of Fannie Mae and Freddie Mac multi-family bonds.

So far, just three agency mortgages have been affected, after the King County Housing Authority seized apartment complexes to guard against them being sold for conversion to luxury properties. But investors worry that such condemnations could become a growing trend in places like Seattle and San Francisco, where giant technology companies have pledged billions of dollars to support affordable-housing efforts.

The problem for bondholders is that when a property is taken by eminent domain, its mortgage is typically paid off at par — without any penalty to compensate for the loss of future interest payments.

King County first used eminent domain to acquire five affordable-housing properties for $245 million in September. The funding for the transaction included $60 million put up by Microsoft, which last year pledged $500 million to support preservation and construction of low-income housing in the region. Alphabet, Apple and Facebook also have pledged a total of $4.5 billion to affordable-housing efforts in California and Washington.

The mortgages on two of the properties acquired by King County backed Fannie single-loan securitizations: a $37 million mortgage on the 240-unit Kendall Ridge in Bellevue and a $33 million loan on the 207-unit Emerson Apartments in Kirkland. A third complex, the 308-unit Riverstone in Federal Way, backed a $30 million loan in the pool of a Freddie deal (FREMF 2015-K718).

After hearing investor complaints, Freddie amended its loan documents, effective Jan. 1, to specify that prepayment penalties will be required if the purpose of the seizure is “continued use of . . . the property for residential purposes” — as opposed to road widening or other public projects that prompt eminent-domain seizures.

Fannie, meanwhile, adopted language Dec. 1 that calls for prepayment premiums, but only for loans in King County. It focused on that area, where it sees a heightened risk of takings via eminent domain, but will continue to monitor the issue, a source said.

But the changes will have little immediate effect, since they don’t apply to mortgages written in past years.

Without prepayment penalties, bond investors who expect to collect interest payments throughout the term of a loan can lose out when they are paid off early. Because interest rates have dropped in the past year, reinvesting the proceeds from seasoned loans would result in lower returns.

Pension funds and other long-term holders of Fannie and Freddie guaranteed bonds typically value them above par. The paper tends to trade that way on the secondary market, in some cases for as much as $1.07 to the dollar. An early pay-off without penalty, then, could mean a loss of principal for a secondary buyer.

“The benefit of buying GSE paper is you are not expecting principal erosion,” said one investor. “If you buy a bond for $1 million, it will trade above that based on how long you can collect that coupon — so in this case, that is money lost.”

In a note to investors on Oct. 1, Morgan Stanley analysts identified $9.3 billion of Fannie and Freddie bonds underpinned by multi-family properties in King County, and suggested that investors “conduct heightened due diligence and surveillance given recent events.” In a separate note, the bank opined that Fannie’s action, revising the language only for future King County loans, didn’t go far enough.

Buysiders acknowledged that the agencies are in a difficult position, given their prime mission in supporting affordable housing. One investor welcomed Freddie’s clarification of its loan documents and said Fannie should take a similar path. “It’s a reputational issue,” the investor said. “You can’t expect Fannie and Freddie to guarantee cashflows over par, but if they don’t do anything, it shakes the confidence of people paying good money for the bonds they issue.”