As prevailing interest rates rise dramatically, the cost of financing new borrowings rises as well. For housing finance agencies (HFAs), this can put upward pressure on the mortgage rates they are able to offer borrowers. As a result, some HFAs are exploring the possibility of using an alternate source of lower-cost funding for new loans – recycling prepayments/prepayments of existing seasoned loans coupled with ongoing lower-rate tax-exempt single-family mortgage bonds. . Some general information and considerations when using recycling strategies:
- Single-family bond resolutions and deeds of trust generally allow loan recoveries to be recycled into new loans, subject to the need to pay current debt service, including expected maturities, required repayments, and payment requirements. regarding CAP obligations.
- Federal tax law generally permits recycling only for the first 10 years from the date of issuance of the related new mortgage bonds that first funded a given loan. (Financial advisers and quantitative consultants generally track the portion of each bond issue (or loan) for which that 10-year period has passed, as repayments and the tendency to combine repayments with additional new silver bonds can complicate the necessary calculations.)
- Some fixed rate bond issues use “closed” tax regimes, in which the bond yield and mortgage yield are calculated at closing or after a relatively short loan origination period, using prepayment assumptions permitted by the applicable tax regulations. [Note – this is not available if any of the bonds are variable rate bonds.] In the absence of subsequent changes, these yield calculations are then used to demonstrate compliance with the arbitrage restrictions applicable to the portfolio of funded loans (such as the maximum positive spread of 1.125% allowed for an issuer) during the term of the bond issue. There is usually no need to update these calculations to reflect actual bond or loan repayment activity. However, when loan collections are used for recycling, it becomes necessary to recalculate bond yield and loan yield to reflect both actual repayment experience to date and actual repayment experience as long as that the recycling continues (unless the loans financed by the recycled collections have the same or lower yields than those of the new initial loans). Once the retraining is complete, a final calculation of bond yield and loan yield can be made based on repayment experience to date and future prepayment assumptions permitted by applicable regulations.
- As suggested above, analysis and calculations will be required to determine which of the existing bond issues of an HFA are amenable to recycling and at what rate. It is possible, for example, that recycling could cause the positive HFA spread on mortgages funded by a given bond issue to exceed the 1.125% arbitrage spread limit. Technical remedies for excess returns, such as paying interest to mortgagors or paying a yield cut to the US Treasury, are available, but very rarely used; instead, HFAs recycle collections into new lower-rate loans (or lower-yielding equity).
- The common method of dealing with excess arbitrage spreads on mortgage portfolios is to use a combination of recycled funds from an existing bond issue and proceeds from the sale of newly issued bonds to jointly fund a pool of loans. Recycled funds from various bond issues could also be pooled to make recycling economical. Subject to certain limits, federal tax rules allow the return of these pools of jointly funded mortgages to be allocated disproportionately between the respective bond issues, allowing HFAs to allocate the return of the mortgage portfolio between the bond issues to meet the Federal Arbitration Terms. HFAs pursuing such a strategy should plan to consult with an attorney to confirm that tax compliance and logistics bases are covered.
If you have any questions about this, please do not hesitate to contact any of the Kutak Rock Housing Finance Agency practice group attorneys.
Single-Family Mortgage Prepayment Recycling – An Alternative to Rising Bond Rates