VANDERBILT CAPITAL ADVISORS

 

 

 

The Federal Housing Authority (FHA) Project Market

 

Introduction

 

The market for Federal Housing Authority (FHA) multi-family home loans represents a large sector of the secondary mortgage market, with an outstanding balance of approximately  $40 billion. These loans have characteristics quite distinct from the traditional single-family mortgage market.  This report provides an overview of these programs and their characteristics as investments.

 

The FHA Multifamily Insurance Program

 

The FHA was created under the National Housing Act of 1934. Developed initially to attract credit to the housing market, the programs primary function has been to enhance the nations multifamily housing stock. To facilitate both the construction and maintenance of multifamily projects, the FHA provides insurance on the financing of construction, purchase and rehabilitation of rental housing projects, condominiums and cooperatives, as well as the refinancing of mortgages on such units.

 

FHA insurance typically provides coverage of 85%-100% of the value of the project with owners' equity making up any amount under 100%. The mortgagee must be an approved lender by both the Department of Housing and Urban Development (HUD) and the FHA.  Mortgagors can be mortgage bankers, commercial banks, savings and loan associations, trust companies, insurance companies and/or pension funds. The types of projects covered under the HUD/FHA mortgage insurance program include hospitals, healthcare facilities and housing for the elderly and handicapped as well as traditional multi-family housing for families.

 

Programs

 

Since its introduction in the early 1930s, the FHA has introduced a vast number of HUD/FHA insurance programs to serve different purposes. Each of these programs is referred to by the section of the housing act under which it was authorized. Given the inherent variations in purpose, each program will have different guidelines and restrictions. These differences will have an impact on the amount of issuance as well as the investment characteristics of the securities which these loans support.

 

The following is a brief  overview of selected FHA programs:

 

Form of

Payment if

Assigned

Section #               Inception               Description                           to HUD                                   Comments

 

207                          1934                        Multi-family Rental              Cash or                  Not a significant force in

Housing (Middle-                debentures            the market today but considered

to Upper Income)                                                 a prototype for later programs

Drawbacks to 207:  (1) a value-

based program and (2) no

 

213                          1950                        Cooperative                          Cash or                  —

Housing                                 debentures

 

221(dX3)                1954                        Rental and                             Cash                       Two distinct groups of outstanding

Cooperative                                                          (dX3) loans: (1) below market

Housing                                                                 interest rate (BMIR) loans, and

for Low-to                                                             (2) market rate loans.

Moderate-Income

Households

 

221(dX4)                1959                        Rental Housing                    Cash                       No BMIRs in the (dX4) program. The

for Low-to                                                             (dX4) program is one of the largest

Moderate-Income                                                of the FMA Project programs.

Households

 

223(f)                      1974                        Existing Housing  Debenture                             Facilitates purchase and refinance

for Moderate-to                                                    of existing projects.  Currently a

High-Income                                                         coinsurance program (lender and

Households                                                          HUD share the risk in event of

default).

 

231                          1959                        Rental Housing                    Cash or                  —

for the Elderly                       debentures

and Handicapped

 

232                          1959                        Nursing Homes and             Cash or                  —

Intermediate Care                 debentures

Facilities

 

236                          1968                        Rental Housing                    Cash, unless         Interest rate subsidy plan.

for Low-to                             the mortgagee       Interest subsidies to be passed

Moderate-Income                files a written        to tenants in the form of lower rent.

Households and                   request for             There is a 40-year prepayment

the Elderly                             payment in            "lock-out" on nonprofit 236 loans

debentures.           and on limited  dividend 236 loans

with rental supplements and a

20-year "lock-out" on limited

dividend loans without rental

supplements.

242                          1968                        Hospitals                               Cash or                  —

debentures

 

Investment Characteristics

 

There are two major events which can affect the performance of these securities. The first is the ability of the mortgagor to prepay and thus unexpectedly shorten the maturity of the security. The second is default, which again, shortens the security but can also affect the investor through the amount and type of proceeds received from HUD.

 

Prepayments

 

Loans in all programs can be prepayed without approval from HUD 30 days after notification by the mortgagor to the mortgagee, except in programs 221(d)(3) and 236. For loans in the 221(d)(3) program prepayments can only be made with HUD approval. Additionally, most loans in this program carry below market interest rates (BMIR), further reducing the incentive to refinance.  Loans in the 236 program also have interest rate subsidies which are passed through to the tenants in the form of lower rent. These loans have a 40 year "lockout" from prepayments because of this subsidy. While there are no BMIRs in the 221(d)(4) program, it does have rent subsidies like the (221(d)(3)) program, and loans originated before November, 1983 may include a very unique "put" feature which allows the investor to exchange the loan certificates for a 10-year FHA debenture with a current market interest rate, for one year after the securities twentieth anniversary.

 

These features can create securities which are highly protected from prepayments due to the lockout and/or low interest rates which typically accompany the underlying loans. Furthermore, the put feature is a hedge against rising interest rates, giving an investor the ability to sell the security at an above market price and reinvest the proceeds in a higher  yielding asset.

 

Defaults

 

Upon default of an FHA project loan the loan is assigned to HUD and the securities can be retired by repayment of the principal balance with cash, the issuance of new debentures in lieu of the FHA project loan, or a combination of both as determined by the HUD Commissioner at time of payment. The new debentures will have a 20 year maturity and will have a coupon similar to the coupon of the initial FHA security. Of all FHA programs only the 221 and the 223 programs must pay either cash or issue a debenture.  The 221 program receives cash and so can be viewed as a prepayment, while the 223 program will receive only debentures. Investors must be aware of how they will be prepayed due to changing market conditions. If cash is received reinvestment rates may be lower than at the time of the original investment, thereby reducing returns. If new securities are received, the maturity of the securities may be different than the securities which were redeemed, producing a different interest rate exposure than originally planned.

 

The stability of these securities due to the prepayment protection and the government guarantee may produce superior return characteristics versus similar government and corporate securities. Below is a table of scenario returns, showing the performance of securities under rising and falling interest rate environments.

 

Total Rates-of-Return

 

    Int Rate Change

 

Security

 

Dur

 

 

 

‑150

 

‑100

 

‑50

 

0

 

50

 

100

 

150

 

UST 8 6.50 10/06

 

6.9

 

 

 

16.4

 

13.2

 

  9.98

 

6.9

 

3.8

 

0.85

 

‑2

 

Merrill Lynch 7.00 3/06

 

6.7

 

 

 

16.2

 

13.2

 

10.3

 

7.4

 

4.6

 

1.9

 

‑0.8

 

FHA Project Note

 

6.7

 

 

 

16.9

 

13.8

 

10.7

 

7.7

 

4.7

 

1.95

 

‑0.6

 

 

 

As shown above, the FHA Project Note outperforms equal duration securities in all scenarios due to the prepayment protection which allows the security to participate fully in a rally, while earning higher yields in a sell off.

 

Conclusion

 

FHA project loans have very unique features which may, on occasion, make them very attractive investments. Few if any mortgage securities have the agency credit quality, high yields and stable investment profiles of  FHA project loans.  Vanderbilt Capital Advisors analyzes both the prepayment and default aspects of these securities to find the most attractive opportunities. We then use these securities in various forms to increase yields in the portfolios while also increasing the credit quality and performance of the portfolios.