Fannie Mae ACES IO Investment

Strategy Overview
FNMA ACES deals are comprised of pooled FNMA Delegated Underwriting and
Servicing (DUS ) loans. The loans have short-stated final maturities associated with
mandatory balloon payments (usually 10 years or less), and have call protection which
typically runs until the final 3 months of the loan.
Most DUS loans require borrower prepayments be accompanied by yield maintenance
penalties (YMP) (as opposed to defeasance, lockout or fixed-penalty points). When
paid, a portion of the penalty is passed through to ACES IO bondholders (usually 70%),
thus providing additional income which may surpass the cash flows of the IO
component, thereby increasing returns.
Deals in the targeted universe are currently carrying mortgage rates roughly 50-200 bps
higher than current rates, which act as incentive for borrowers to prepay to refinance
sooner, as perceptions are that rates are expected to rise in the near future.
Any YMP paid by borrowers are generally capitalized into a new mortgage, so the
combination of a new lower mortgage rate, along with the interest deduction taken for
payment of the penalty, can make the short-period breakeven time a more practical
business decision compared with risking higher mortgage rates while waiting for
penalties to burn off.
Replacement of durable goods necessary in multifamily buildings usually occurs
around the 7-year timeframe, combined with mandated balloon payoffs in 7-10 years,
borrowers are more willing to refi slightly earlier to capture lower rates.
Many of the loans underlying the targeted securities currently enjoy embedded equity
ranging from 50%-150% of appraised value, making earlier refinancing desirable to tap
equity embedded in the properties as soon as possible.
Majority of underlying loans in this program were originated in the post-subprimecalamity time period, and were subject to higher underwriting scrutiny and therefore
tend to be more stable. Both Fannie and Freddie were under tremendous political and
regulatory pressure to be disbanded during this period, so any loans made during this
period tended to be underwritten exceptionally well.
All indications are that the FED is poised to continue to raise rates, so borrowers may
try to get ahead of the FED and lock in lower rates as soon as it becomes
economically reasonable to do so.

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ACES IO Strategy Overview

Fannie Mae ACES IOs can offer a unique
investment opportunity due to the distinctive
attributes of the underlying pooled Fannie Mae
DUS loans, upon which the ACES securities owe
their
cash
flows.
Historical
prepayment
performance of 190 Fannie Mae ACES loan pools,
totaling $57.64 billion, along with the universe of
applicable Fannie Mae DUS loans (totaling almost
$200 billion) clearly illustrate the correlation
between observed faster prepayment speeds and
the shortening of time until maturity balloon.
Driving this strategy is the receipt of YMP payments
to bondholders, associated with faster prepayment
speeds on the underlying DUS loans, which can
complement the traditional interest-only class
investment yields.
Obviously, prepayments may not benefit all ACES
IO securities, but for those where the underlying
DUS loans exhibit the desired metrics, and the
associated IO securities are priced appropriately,
the combination may result in increased returns.
Historical prepayment performance analysis of
Fannie Mae ACES pools originated since 2009,
clearly illustrates a prepayment speed ramp-up
over time, which increases as the underlying loans
trend towards their balloon maturities. A similar
ramp is seen when the larger universe of DUS
loans is analyzed. The results of these analysis are
discussed below in the Fannie Mae DUS
Prepayment Performance section.
Although loan prepayment activity is fundamentally
related to traditional economic triggers such as

interest rates and asset valuations, multifamilyborrower behavior plays a significant role in the
decision of when loan payoffs occur. Unique to
multifamily properties, is the need to replace the
durable goods (i.e. refrigerators, stoves, etc.)
provided in each housing unit. Reaching the end of
their operative lives, the necessary replacement of
these amenities can result in earlier loan
prepayments as borrowers look to recapture
replacement costs and take advantage of higher
appraisal values associated with new equipment.
This often-overlooked component of borrower
behavior is a meaningful contributor in the decisionmaking process multifamily owners must consider
when deciding when to pay off their existing loans.
Extensive use of yield maintenance penalty call
protection, along with limited knowledge of
multifamily borrower behavior, creates a product
line in which many investors are unfamiliar. This
blind spot presents an opportunity where
knowledgeable investors can financially benefit by
taking advantage of potentially higher returns
associated with educating themselves on an offthe-run investment opportunity.
The strategy outlined herein is predicated upon the
performance of the Fannie Mae DUS loans
underlying these securities, along with an
understanding of how borrower behavior affects the
timing of the associated cash flows. Given the
importance of these aspects to the performance of
the strategy, a brief overview of the Fannie Mae
DUS program, along with the associated
multifamily-borrower behavior, has been included to
help familiarize the reader with the concepts
underlying the investment strategy.

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Fannie Mae DUS Program Overview

Fannie Maes Delegated Underwriting and
Servicing (DUS) program was created in 1988 to
drive,
enhance
and
maintain
product
standardization in the multifamily marketplace.
Fannie Maes multifamily book of business totals
more than $300 billion financed since 2000, with
over $40 billion originated in 2015 alone. This is a
unique business model in the commercial mortgage
industry (with the exception of a less frequently
used FHA risk-sharing product). Standard industry
practice is for a loan purchaser or guarantor to
underwrite or re-underwrite each loan before
making a decision to purchase or guaranty it.
Under the DUS model, designated lenders are
authorized to commit Fannie Mae to acquire
multifamily loans. The loans must be underwritten,
originated and serviced according to standards
established by Fannie Mae. In exchange for this
authority, DUS lenders must share the risk of loss
over the life of the loan, generally retaining onethird of the underlying credit risk on each loan sold
to Fannie Mae. DUS lenders must post collateral to
secure their risk sharing obligations1.
Under the DUS program, approved lenders can
originate fixed-rate, adjustable-rate, balloon, fully
amortizing, partial and full-term interest-only
multifamily mortgage loans. These DUS loans can
be financed through MBS, DMBS, or Bond Credit
Enhancement executions. The most common final
balloon maturities for fixed rate multifamily loans
are 5, 7, 10, 12, and 15 years, while adjustable-rate
mortgage loans usually have final balloon
maturities of 5, 7 or 10 years. The most common
DUS MBS is a 10/9.5 fixed rate (a 10-year balloon
with 9.5 years of yield maintenance), followed by
the 7/6.5 fixed rate (a 7-year balloon with 6.5 years
of yield maintenance)2.
Table 1: Types of Multifamily Mortgaged Properties Eligible for DUS MBS
Property Type

Description

Standard Conventional Multifamily

A multifamily loan secured by a residential property composed of five or more dwelling units and in which
generally no more than 20 percent of the net rentable area is rented to, or to be rented to non-residential
tenants.

Multifamily Affordable Housing and Low- A multifamily loan on a mortgaged property encumbered by a regulatory agreement or recorded restriction that
Income Housing Tax Credit
limits rents, imposes income restrictions on tenants or places other restrictions on the use of the property.

Page | 3

Seniors Housing

A multifamily loan secured by a mortgaged property that is intended to be used for elderly residents for whom
the owner or operator provides special services that are typically associated with either independent living or
assisted living. Some Alzheimers and skilled nursing capabilities are permitted.

Manufactured Housing Community

A multifamily loan secured by a residential development that consists of sites for manufactured homes and
includes utilities, roads and other infrastructure. In some cases, landscaping and various other amenities such
as a clubhouse, swimming pool, and tennis and/or sports courts are also included.

Cooperative Blanket

A multifamily loan made to a cooperative housing corporation and secured by a first or subordinate lien on a
cooperative multifamily housing project that contains five or more units.

Dedicated Student Housing

Multifamily loans secured by multifamily properties in which college or graduate students make up at least
80% of the tenants.

1
2

An Overview of Fannie Maes Multifamily Mortgage Business, May 2012

Over Twenty Years of Multifamily Mortgage Financing Through Fannie Maes Delegated Underwriting and Servicing (DUS) Program, March 2015

Manufactured Housing. Various asset classes are

described in the associated Multifamily MBS
Prospectus.
Table 2: Tier Level Credit Characteristics
Rating

Minimum DSCR

Maximum LTV Ratio

Credit Quality of DUS Mortgage Loans

Tier 2

Generally no lower than 1.25

Generally no higher than 80%

Eligible multifamily properties must be incomeproducing multifamily rental properties or

cooperatives with a minimum of five individual
units. These multifamily properties must be
existing, recently completed, or in need of
moderate rehabilitation. A majority of the properties
qualify for 30-year amortization schedules. A DUS
mortgage loan tends to range in size from $1
million to $50 million and is generally nonrecourse3 to the borrower. Additionally, DUS loans
generally are assumable after a review of the
proposed transferee, although a one-percent
transfer fee payable to Fannie Mae is commonly
charged, which is not passed on to the MBS
investor.

Tier 3

Each mortgage is underwritten to a three-tier credit

structure based on debt service coverage ratio
(DSCR) and loan-to-value ratio (LTV). Table 2
summarizes the LTV and DSCR values for each tier
for standard conventional multifamily loans. DSCR
and LTV requirements are subject to change based
on market conditions. Stricter underwriting
standards apply to other asset classes such as
Seniors
Housing,
Student
Housing,
and

Tier 4

Usually falling within a range of Usually falling within a range of

1.35 1.55
65% 55%
Usually in excess of 1.55

Usually below 55%

In addition to tier assignments, each property

underlying the multifamily MBS is subject to three
assessments.
1. An appraisal of the property is performed by a
licensed appraiser selected by the DUS lender.
Appraisals must conform to Uniform Standards
of Professional Appraisal Practice (USPAP)
standards. Fannie Mae does not approve
specific appraisers. The DUS lender is
responsible for selecting the appraiser and is
solely accountable for their performance.
2. Either an environmental assessment or an
American Society for Testing and Materials
(ASTM) screen is required and an ongoing
operations and maintenance plan may also be
required to ensure the property is operated in an
environmentally sound manner.
3. A physical needs assessment must be
completed by a qualified evaluator designated by
the DUS lender. If tenant safety, marketability, or

Page | 4

property conditions are compromised by

unacceptable circumstances, repairs may be
ordered. Generally, if the repairs are not
completed by the time of closing, a reserve fund
for payment of the repairs may be established.

It is important to note that the underwriting

guidelines in the DUS Guide are guidelines and not
rigid requirements. A waiver or exception may be
granted if it is deemed by Fannie Mae to be prudent
given the applicable circumstances4.

DSCR and Net Operating Income (NOI), is

collected by Fannie Mae and disclosed on an
annual basis.
* These figures are not an indication of the DSCR or LTV characteristics that will apply to any
given MBS, regardless of Tier. The DSCR, LTV and Tier for each MBS are disclosed in the
offering documents for that MBS.

3
4

Non-recourse: In the event of default, the lender agrees to take the pledged property as satisfaction for the debt and to have no claim on any other assets of the borrower.
Over Twenty Years of Multifamily Mortgage Financing Through Fannie Maes Delegated Underwriting and Servicing (DUS) Program, March 2015

prepayment premium is based on a standard

calculation, but is, at a minimum, 1% of the
outstanding unpaid principal balance of the loan at
the time of payoff, during the YMP period.

DUS Prepayment Protection

As part of the DUS program, each DUS loan
generally has voluntary prepayment protection
provisions. For fixed-rate loans, the prepayment
premium is usually a yield maintenance premium
(YMP) or a declining percentage of the unpaid
principal balance. Other methods for calculating
prepayment premiums are also possible. The
prospectus supplement will specify whether the
loans in an MBS pool have prepayment premiums
and, if so, will specify the method for calculating the
prepayment premiums. The prospectus supplement
will also state whether certificateholders share in
any prepayment premiums collected on prepaid
loans in the pool and, if so, will describe the method
of allocation.
Yield maintenance, the most common form of
prepayment protection, allows for full prepayments
along with a yield maintenance prepayment
premium payable by the borrower. The yield
maintenance prepayment premium for each
mortgage loan is payable during a period of time,
the yield maintenance period. If a borrower
voluntarily prepays a mortgage loan during the yield
maintenance period, the yield maintenance

It is important to note that Fannie Mae calculates

the share of the prepayment premium to be
retained by the company and the share of
prepayment premium to be passed on to the
investor.
Fannie Mae will pass the yield
maintenance prepayment premium to the investor
only to the extent that collected premiums remain
after the company has deducted its full portion.
Fannie Mae does not guarantee payment of any
prepayment premiums and Fannie Mae will only
pass through the MBS investors portion of a yield
maintenance payment to the extent it is collected. If
a borrower prepays a mortgage loan on or after the
yield maintenance end date, Fannie Mae will not
pay any portion of the prepayment premium to the
investor.
The Treasury reference note used to compute the
yield maintenance prepayment premium effectively
increases this premium by the present value of the
spread differential between a DUS MBS and
Treasuries. If the borrower prepays during the three
months after the end of the yield maintenance
period, the borrower may be charged a one percent
prepayment premium based on the amount of
prepaid principal. Prepayment premiums paid in
connection with prepayments occurring after the
yield maintenance end date are not passed through
to MBS investors.

Page | 5

Fannie Mae publishes a Monthly Yield Maintenance

Factor report which investors can use to calculate
their share of yield maintenance for those MBS
paying yield maintenance in the current month.
The various prepayment protection methods on
DUS loans provide considerable compensation to
investors and reduce the incentive for a DUS loan

to be repaid before the prepayment end date

(curtailment). Voluntary partial prepayments
generally are prohibited on DUS loans. Involuntary
prepayments such as condemnation awards or
insurance proceeds may occur. Investors can
determine the prepayment premium or yield
maintenance formula that applies to the loan
underlying a particular MBS by reading the
Prospectus Supplement for that MBS type5.

Over Twenty Years of Multifamily Mortgage Financing Through Fannie Maes Delegated Underwriting and Servicing (DUS) Program, March 2015

Fannie Mae DUS REMIC Programs

Fannie Mae DUS REMICs, also called ACES or
GeMS, represent an alternative way to gain
exposure to multiple DUS MBS pools. In contrast to
the homogenous pass-through deal structure of a
DUS Mega, a DUS REMIC typically consists of
sequential-pay classes (often with par coupon
pricing) and an IO class (Figure 1). Current
outstanding DUS REMIC volume is in excess of
$80 billion. The average deal size is around $550
million, consisting of more than 100 DUS MBS
pools per deal, on average, at issuance. The
underlying pools in REMICs are predominantly
standard multifamily (84%), followed by cooperative
loans
(6.5%)
and
manufactured
housing
communities (4.8%). Unlike the clustered DUS
MBS pools in a Mega, the range of coupons within
a DUS REMIC can be much wider, such as in FNA
2010-M7, in which coupons ranged from 4.64% to
7.14% (or 250 bps). DUS Megas can also be part
of the collateral in DUS REMICs. Upon voluntary
prepayment, the IO class usually receives 70% of
the YM penalty, and the current pay bond receives
the remaining 30%6.
Fannie Mae Guaranteed Multifamily Structures
(Fannie Mae GeMS) are structured multifamily

securities created from multifamily MBS collateral

selected by Fannie Maes Multifamily Capital
Markets Desk. The Fannie Mae GeMS program is
an umbrella for all Fannie Mae portfolio structured
multifamily products. The program was launched in
2011 and includes Multifamily Megas and REMICs.
The program attracts additional capital to
multifamily finance from larger institutional investors
who might not find the characteristics of smaller,
single-loan DUS MBS attractive. GeMS provide
par-priced, block size, structured securities with
collateral diversity and customized cash flows to
meet investor demand7. In 2015, Fannie Mae
issued $11.7 billion in GeMS.
Fannie Mae Alternative Credit Enhanced Securities
(Fannie Mae ACES) are structured multifamily
securities created from multifamily MBS collateral
and are similar in structure to GeMS securities.
Fannie Mae ACES are REMICS backed by
MBS/DUS securities which are structured into
sequential, bullet, IO, floater and inverse floater
classes. The ACES program predates the GeMS
program, but is similar in that both allow inclusion of
multiple prefix pools, have no coupon range
requirements and are created through Fannie
Maes FNM Structured Transactions conduit. Both
also allow for collateral diversity, improved liquidity
by block-size securities offerings and allow for
customized cash flows to meet investor demand8.

Figure 1: Sample Fannie Mae DUS REMIC deal

Page | 6

6,7
8

Credit Suisse, Agency CMBS Market Primer, September 21, 2011

FNMA, ASF 2011: Fannie Mae Securitization Overview, February 2011

THE 10-YEAR BALLOON A LESSON IN HISTORY

Ever stop to consider why the vast
majority of non-agency CMBS loans have
balloon maturities (in the form of
Anticipated Redemption Dates ARD),
and most Agency CMBS loans (excepting
GNMA) carry explicit 10-year balloon
language? Is it just a coincidence that
Commercial Mortgage Backed Securities
(CMBS) loans carry call protection no
longer than 10 years? What is so special
about that 10th year? Current use of 10year terms for CMBS call protection and
balloon periods owe their roots to
multifamily properties once being the
sole securitized CRE collateral type.
It would be expedient to say that the
choice of 10 years term for balloon date
and maximum call protection was simply
a matter of convenience, but looking
back to the earliest days of commercial
real estate securitization confirms that
the 10-year term was not an arbitrary
choice. The two main reasons why trace
their roots back to the early days of CRE
financing.
Although current commercial real estate
securitizations include loans made on
many different property types, this was

not always the case. Prior to the creation

of CMBS in the early 1990s, the only
public securitized CRE program was one
confined to multifamily lending through
the securitization of Federal Housing
Authority (FHA)-originated loans. The FHA
multifamily program was established to
focus exclusively on those properties
associated with Section 8 voucher and
Housing
Assistance
Program
(HAP)
programs, as the idea was to increase
financing opportunities on lower-quality
affordable-housing
buildings.
Initially,
these loans were guaranteed solely by
the FHA (at a slight discount, issuing
debentures in the event of default), but in
the early 1970s, individual FHA-originated
loans
were
further
wrapped
and
guaranteed by Ginnie Mae, creating a
program that was more
widely accepted by investors looking for
the security of a U.S. government
guarantee,
combined
with
timely
payment and ultimate payment pledges.
Due to the nature of the underlying
collateral (typically, housing projects), the
name Project Loan stuck, and has been
used since to describe multifamily

Page | 7

housing loans associated with low-tomoderate-income properties (customarily,

the name is reserved for GNMA Project
Loan Certificates (GNMA PLC), but has
been used in other contexts as well).
Prior to the sweeping tax reform changes
enacted in 1986 (Tax Reform Act of
1986), investors in commercial real
estate properties were able to enjoy what
was known as accelerated depreciation.
This tax loophole allowed property
owners to depreciate their CRE properties
over a 12 -year periodroughly 1/3 of
the typical 35- to 40-year amortization
termresulting in significant savings. As
the
advantages
of
accelerated
depreciation approached the end of the
12 -year period, property owners
actively sought to sell their properties for
new ones, effectively exchanging them
and thus, re-setting the depreciation
clock. Given the time necessary to find
new target properties, along with the
process of selling their current property,
the majority of transactions occurred
somewhere between the 10th and 12th
years of the original mortgage term.
Accelerated-depreciation
exchange
activity was not limited to multifamily
properties, but as described below,
multifamily buildings have a separate and
unique quality which exacerbated the
effect.
Considering the nature of multifamily
properties unique characteristics relative
to other CRE property types, an
interesting and sometimes-overlooked
aspect of borrower behavior becomes
significant. Consider for a moment that a
multifamily property is, simply stated, an
aggregation of a number of small

homes contained in a single structure.

In each of these homes is found a number
of standard appliances (i.e. refrigerators,
ovens, dishwashers, etc.), referred to in

aggregate as durable goods, for which

the building owner is responsible to
provide. These durable goods typically
have a life expectancy of somewhere
between 7 and 10 years. It can be further
argued
that
the
builder-quality
amenities often found in apartments tend
to be of slightly lower quality and thus
may need to be replaced earlier than
comparable amenities found in private
homes.
Given that the majority of these durable
goods will likely begin to reach the end of
their usefulness around the same time,
multifamily property owners recognize
that once some of the items need to be
replaced, there is a very high likelihood
that the remainder will need to shortly
thereafter. To lower costs, property
owners tend to buy the replacement
items in bulk, and attempt to complete
the replacement of these items at one
time. Because the cost of replacement,
although
meaningful,
represents
a
relatively small percentage of the value
of the asset, property owners tend to pay
replacement costs out-of-pocket as
opposed to taking out a supplemental
loan. With the funds coming out of
operating income, property owners are
incentivized to want to quickly refinance
or sell to get that money back.
Historically, this activity usually occurs
somewhere between the 7th and 10th
years.
Prior to 1986, if a multifamily property
owner was incentivized to sell his
property prior to the 12th anniversary of
his outstanding loan to restart the
accelerated-depreciation clock, and also
had to replace the durable goods in his
building, he would elect to sell or
refinance right after the replacement of
the durable goods. This helped ensure he
would
receive
the
highest
appraisal/valuation on the property. The
timeframe where necessary replacement

Page | 8

of durable goods coincided with the

runoff of the depreciation credit was
referred to as the cross-over period.
Although each property had its own
specific circumstances, the tendency was
for these events to occur around the 10 th
year.
Recognizing that their loans would
remain outstanding for around 10 years,
these borrowers adopted the practice of
buying down their loan rates by
including prepayment penalty covenants
for the first 10 years of their loans. Since
the likelihood was low that they would
have to exit their loans early, including
call-protection provisions on their loans
impacted their operations little, yet was a
benefit in lowering mortgage costs.
Since being implemented, the Tax Reform
Act of 1986 replaced the accelerateddepreciation loophole with the now-

Fannie Mae DUS Prepay Performance

Historical performance data of more than 190 loan
groups (totaling $57.64 billion) within the targeted
universe of Fannie Mae ACES deals confirms that
as the underlying DUS loans approach their
mandatory balloon dates, prepayment speeds
increase rapidly (Figure 2). Many of these loans
pay off with yield maintenance penalties, a
significant portion of which (usually 70%) are
passed through to IO class bondholders, boosting
returns.
Pooled REMIC securitizations (such as ACES
deals) offer monthly performance updates which
allows for more granular surveillance of loan paydown activity. This increased transparency clearly
illustrates the prepayment ramp speed pickup
phenomena as loans move towards their balloon
maturities. Observed speeds vary by loan
composition, but the trend is clear: as loans move
inside the final 48 months until maturity,
prepayment speeds ramp up asymptotically
towards maturity, with a significant number of loans
prepaying with penalty payments.

current
straight-line
depreciation
deduction, which permits depreciation of
CRE holdings over a longer, 29 -year
schedule. Although the change in the tax
code removed the depreciation-savings
incentive to sell properties prior to the
12th year, multifamily borrowers still
needed to recoup the cost of the
replacement of durable goods. Because
of this necessity, multifamily property
owners found themselves more amenable
to refinancing rather than selling, but the
10-year timeframe remained consistent.
With the arrival of CMBS securitization in
the early 1990s, although non-multifamily
property types were introduced into the
marketplace, the convention of 10-year
loan
payoffs
and
call
protection
provisions, established over many years
of multifamily property activity, became
the norm, and remains today.

Figure 2: Fannie Mae ACES Speeds vs WAM

AC ES Average P repay S peeds
( April 2016)

CPR

6 Month S peeds

12 Month S peeds

60%
50%
40%
30%
20%
10%
0%

Remaining WAM (yrs)

Additional analysis of the entire applicable

universe of Fannie Mae DUS loans (~$200 billion),
encompassing
the
most
commonly-issued
structures found in ACES deals (10/9 and 5/4),
covering the past 15 years performance, resulted

Page | 9

in the clear emergence of prepayment patterns

which further corroborates the direct relationship
between shorter loan WAM periods and higher
payoff speeds.
It is important to note that not all DUS loans are
securitized into ACES deals, but all ACES deals are
backed by pools of DUS loans. Therefore, although
the data from the larger universe of DUS loans is
not directly applicable to any specific ACES
security, the prepayment ramps which emerged are
an important confirmation of the performance of the
collateral group as a whole.
DUS payoff data, available on Fannie Maes
website is updated quarterly, but is segmented into
annual cohorts. Despite being less granular than
the monthly-reported ACES data, the Fannie Mae
data offers further corroboration that the
prepayment patterns noted in ACES deals are
Using trailing 6-month prepayment speeds on
ACES deals, the correlation between remaining
WAM to balloon and prepayment speed is
graphically illustrated below (Figure 4). Note the
high correlation of faster speeds on those loan
groups with shorter balloon WAMs. Shorter cohorts
can illustrate the correlation in more granularity, but
due to the relatively small amount of loans in each
deal (typically 100-150 loans at origination), shorter
timeframes produce more volatile speeds between
periods, since a single loan payoff of a larger loan
may skew the data in a shorter observed period.
Trailing 6-month averages were chosen to capture
payoff trends, yet maintain a true representation of
speeds by smoothing the curves over a reasonable
near-term timeframe.

consistent in the broader DUS universe, as would

be expected (Figure 3).
Figure 3: Annual DUS Prepay Speeds by
Vintage
His toric al DUS P repay S pee ds
( 2000-2015)
( annual c ohorts )
100%
80%
60%
CPR

40%
20%
0%

It should be noted that this analysis, although

confirming the presence of faster prepayment
speeds as loans trend towards their balloon
maturities, is not intended to create a universal
prepay speed curve to be applied to all ACES loans
groups, but rather, to identify the speed pick-up
trend specifically associated with this collateral
type.
Each loan group underlying ACES deals has
unique qualities specific to that group, and
therefore needs to be evaluated individually to
forecast future prepayment expectations. Factors
used to gauge future speeds include: loan
origination dates, gross WACs, remaining time until
balloon, penalty costs/pass-through amounts and
property equity.

Figure 4: ACES Loan Group Prepay Speeds (6-month rolling averages) vs Remaining WAM

Page | 10

FN ACES Prepay Speeds

(6mo Rolling Averages - April 2016)
Outstanding FNA ACES Pools
<--Later Originations
11

100

10

90

80

70

CPR %

Earlier Originations-->

6
5
4

60
50

Loan WAM (yrs)

40

30

20

10

Fannie Mae DUS Prepay Motivation

Economics of Time Value
Traditional expectations apply when considering
prepayment probabilities on loans where the
borrowers in-place mortgage rates are higher than
the current rate environment. Obviously, this will be
tempered by the amount of penalty charged for an
early payoff, but historical performance has shown
that even with larger penalties, some borrowers will
elect to pay penalties if they believe rates are
headed higher, for fear of missing out on the
opportunity to lock in lower rates.
It is somewhat counter-intuitive to believe a
borrower will pay a high penalty to refinance, but
other factors weigh in to the borrowers motivation:
Borrowers utilizing the Fannie Mae DUS program
are aware that they must pay off their loans by the
stated balloon maturity date. Unlike traditional
CMBS where balloon payoffs are considered
anticipated, and can be extended by the Special

Servicer, Fannie Mae will immediately remove any

delinquent or matured loans (up to 60 days grace)
and pay off the remaining balance to bondholders
via the Fannie Mae guarantee. This hard final
makes borrowers acutely aware they need to insure
they have a takeout strategy in place before the
loan reaches maturity, or risk losing their property.
Knowing that they need to have an exit strategy,
borrowers are more inclined to act earlier to avoid
triggering a default event if something delays their
take-out strategy. If they can refinance into a new
mortgage that is significantly lower than their
current rate, they tend to do so more readily
particularly if they believe rates are headed higher
in the near future.
This phenomena has its basis in the fact that if a
borrower knows he has to pay off his current loan in
the next 2 or 3 years, and there is a likelihood of
higher rates on the horizon, even with paying
prepayment penalties, the cost of that penalty can
be made up with a lower loan rate. If by waiting

Page | 11

for the penalty to decrease, rates move higher, it

can result in an economically worse financial
situation.
Example:
If a loan requires a 10-point penalty to prepay
today, and a new loan is 200 bps lower in rate
than the current mortgage rate, the penalty
would be made up by the 5th year of the new
loan (200bps savings/year x 5 years =
1000bps).
Alternatively, if a year later, the penalty
dropped to 8%, but rates rose 100 bps, a
borrower would then have to recoup the 8point penalty cost with a new loan that is only
100 bps lower than the old rate, thereby
requiring 8 years to break even thus making
the decision to refi earlier and pay the 10point penalty, a more prudent business
decision.
Additionally, any penalties paid to exit a loan can be
capitalized into the new loan, as well as taken as a
tax deduction, somewhat softening the blow of
paying the penalty.
Remember that these borrowers are in the
business of leveraging their properties. Unlike a
residential borrower whose goal is to completely
pay off his loan and own the property outright,
multifamily borrowers are not trying to completely
pay down their loans, rather, they want to leverage
their properties to achieve the best performance
against their business activities. As such, even
paying a high penalty may make more financial
sense than waiting for lower penalties if they can
lock in a lower mortgage rate to defray the net cost.

Borrower Behavior
Multifamily, as a property type, is unique in the
commercial real estate space in that it is the only
property type where property owners are faced with
the task of periodically replacing consumer durable
goods contained in each apartment unit. Durable
goods, in this context, refer to the typical residential
appliances found in most apartment units. Although
the strategy outlined herein applies to multifamily
borrowers within the Fannie Mae DUS program, the

multifamily-borrower behavior related to the

replacement of durable goods described below, is
not limited to any specific loan platform. It is
however, important to recognize that this behavior,
when combined with hard balloon maturities such
as those found in the DUS program, can result in
loan prepayments earlier than may be normally
expected.
Borrowers in Fannie Maes DUS program know that
they must sell or refinance their properties prior to
loan maturity. Although empirical data is scarce,
based on anecdotal knowledge, the majority of
these borrowers tend to be in the business of
owning and operating multifamily properties, and
therefore many elect to refinance their properties
rather than sell. In either case, whether they
choose to sell or refinance their loans, borrowers
attempt to garner the highest appraisal (if
refinancing), or sale value for their properties to
receive either the most leverage or sale proceeds
possible.
To obtain the highest valuations, the building and
units need to be in the best-possible condition. This
requires the borrower to perform routine
maintenance as well as the periodic replacement of
old appliances in the individual units. It is in the
borrowers best interest to complete any necessary
work prior to a sale or securing a new loan since
upgrades usually translate into higher property
valuations.
A multifamily property is, simply stated, a cluster of
small homes contained within a single building.
Each of these homes typically has included in each
unit standard appliances such as refrigerators,
ovens, air-conditioners, etc. The average useful life
of these durable goods tends to be around 7-10
years. Most property owners, in an effort to save
money, choose builder-grade appliances, which
tend to be of lesser quality and therefore need
replacing towards the shorter end of the
obsolescence curve. It is a reasonable assumption
to expect that once the first few appliances need
replacing, the remainder will follow shortly
thereafter. To this end, property owners typically
buy replacements in bulk, and switch out all of the

Page | 12

appliances in the building at one time, to save

money.
Considering the time necessary to order the goods
and complete the work, borrowers have historically
undertaken beginning the process with around 2-3
years to go before the outstanding loan maturity to
insure that any unforeseen delays do not run up
against the loan maturity dates. Since these
financial outlays are reasonably large and are a
cash drag on the borrower, once completed,
borrowers tend to want to recover the expenses as
soon as possible. Because this work occurs at a
point that is not too far from the time the loan is due
to mature, taking out a short supplemental loan isnt
practical. The costs associated with these upgrades
usually comes out of the propertys operating
capital. Borrowers will need recoup the outlay by
refinancing or selling the property. These factors
usually translate into earlier payoffs of the existing
loans.
The borrower behavior described above tends to be
a universal practice, but given the current interest
rate environment and expectations of higher rates
in the not-too-distant future, the combination makes
for a very compelling incentive for borrowers to
want to refinance their loans sooner in the cycle
than if prevailing mortgage rates were equal to or
higher than in-place rates.
As described, although paying penalties will figure
into borrower math as to the timing of existing loan
payoffs, the facts are that these loans will have to
be paid off relatively soon, and the combination of
currently low mortgage rates with the strong desire
to recapture upgrade/maintenance expenses is a
very compelling incentive to act sooner rather than
wait and try to time the market. The data compiled
and highlighted in the charts above illustrate that
borrowers within the targeted universe are indeed
prepaying despite the penalty payments. Any rise in

interest rates should only intensify this activity as

borrowers feel they miss the opportunity to lock in
lower rates if they dont act quickly.
Remarkably enough, when data from each of the
2000-2003 and 2009-2012 timeframes are
analyzed (periods of consistantly falling interest
rates), the early payoff phenomena is still present.
Despite lowering rates along with prepayment
penalties that were also trending down, a significant
number of DUS borrowers still elected to prepay
their loans early and pay the penalties. Although
the actual motives for this borrower behavior
cannot be known with certainty, the reasoning
described above offers a plausible explanation.

Fannie Mae Multifamily Underwriting

With respect to loan performance and default
expectations, note that Fannie Mae has been
engaged in the multifamily sector since 1988, and
currently has almost $200 billion of multifamily
loans outstanding. According to Fannie Maes data,
loans owned or guaranteed by Fannie Mae have
enjoyed extremely low default histories. Recently,
serious delinquency rates were quoted by Fannie
Mae at 0.05%9.
Also noteworthy is the understanding that along
with the characteristically conservative underwriting
criteria that Fannie Mae utilizes, loans comprising
the targeted universe of our strategy were
originated during the post-subprime-crisis era, in
which both Fannie Mae and Freddie Mac were
under tremendous political pressure. Remember
that during this period, congress was seriously
considering disbanding both GSEs. The intense
scrutiny resulted in loans originated during this
timeframe to be especially clean since neither
agency wanted to have to explain any negative
events and give any additional reason to shut them
down. Even today, both Freddie Mac and Fannie
Mae remain in conservatorship.

Page | 13

Source:

Fannie

Mae

Business

Information,

February

2016

Source: Fannie Mae Business Information, February 2016

Fannie Mae, Fannie Mae Multifamily Mortgage Business Information, February 2016

ACES IO Market Imbalance

Fannie Mae ACES IO securities represent a small
subset within the Fannie Mae multifamily program,
which itself, is a subgroup of the broader Agency
CMBS universe. Because of its limited size, ACES
IOs attract less investor attention. Combined with
the steeper learning curve associated with the
ACES/DUS programs, including the unique impact
of multifamily borrower behavior, ACES IOs are
often overlooked by investors. The confluence of
these factors creates a supply/demand imbalance.
Approximately $60 billion (original face) of ACES IO
bonds have been issued to date. When factoreddown balances (current face) and discount pricing
are taken into consideration, the investable market
of these securities shrinks to around $2.5 billion.
With a significant portion of these bonds likely to
remain in account hands, it is estimated that the
actual amount of market-available ACES IO
securities is between $50 and $200 million
annually. When considering the amount of
investable dollars available in IO classes structured
off of ACES deals, it quickly becomes apparent that
this smaller corner of the CRE market can be easily
overlooked.

Risk/Reward Tradeoff
Traditionally,
higher-yielding
investment
opportunities are associated with a higher risk
profile, balancing against the potential of greater

returns. ACES IOs, although not immune to

downside risk, can offer investors a different
risk/reward tradeoff due to the relative short
duration of the securities, combined with the
tendency of the underlying collateral to perform as
expected.
All DUS pools have hard balloon maturities, which
in the universe of ACES IO class securities targeted
for the strategy, tend to have relatively short
timeframes (typically 1-5 years). Assurance that the
loans will pay off by maturity (Fannie Mae
guarantee), allow investors to know the absolute
longest period of time the associated IO securities
will last. Combined with the presence of the
established historical prepayment curves, a
reasonable expectation of worst case early
amortization events may also be achieved. Note
that any prepayments during the YPM period will be
accompanied by penalties passed through to
investors, potentially offsetting IO coupon loss, and
in many cases, can increase yields as compared to
the traditional IO cash flows. These boundaries
allow investors the opportunity to apply
conservative downside scenarios to potential
investment securities to optimize the risk/reward
profiles.
The FNA ACES IO strategy exploits the high
probability of early loan payoffs (with accompanying
penalty payments to bondholders) on the
underlying collateral, and leverages the structure of
these securities to produce returns which may
exceed standard IO cash flow returns. By targeting
those IO classes backed by loan pools exhibiting
the characteristics which best capture the

Page | 14

performance desired, investors can better manage

risk/reward metrics.

100%CPY and the Asteroid

Typically, a 100%CPY assumption is used to
analyze a worst case scenario on securities with
prepayment penalties on the underlying loans. This
assumption implies the earliest payoff scenario
without receipt of any penalties being paid to
bondholders. Although mathematically correct, the
application of 100%CPY on Fannie Mae ACES
securities as a worst case scenario is inaccurate,
ill-advised, and can significantly misrepresent risk.
Working in concert, there are a number of factors
which contribute to the very high likelihood that a
significant amount of borrowers will not pay off
their loans right when the YMP period ends.
These factors are as follows:
1) Although the borrowers YMP period
typically expires 6 months from maturity, the
additional 1% penalty imposed by Fannie
Mae (which is not passed through to
bondholders) extends the borrowers
actually penalty period up until the final 3
months of the loan. Even though 100%CPY
is mathematically correct in the assumption
that penalties expire when the YMP ends,
the 100%CPY assumption does not take
this additional penalty into consideration. It
is therefore reasonable to expect that if a
borrower gets to within the final 6 months of
the loan, he may consider holding off just
another 3 months to avoid paying any
penalties at all.
2) When calculating YMP, the formula takes
into consideration a number of salient
factors to arrive at the amount of penalty
due. This formula also has a provision that,
in no case will the minimum YMP be lower
than 1% of the UBP. Mathematically, the 1%
minimum threshold typically is reached
about 3 months prior to the actual end of
the YMP period. Given that a penalty will go
no lower than the minimum, borrowers must
decide if they will wait until the penalties
expire, or pay the 1% minimum. As stated
above, if they wait, they will likely be paying

off after the YMP end date, which is longer

than the 100%CPY assumption, if they
choose to pay the 1% minimum, it is likely
that they will do so as early as possible to
be able to recapture expenses, tap any
latent equity, and secure new financing. In
either case, the 100%CPY payoff point will
likely be missed.
3) Discussed in the sections above, borrower
behavior is a significant contributing factor
in the timing of when loans tend to prepay.
As has been illustrated, historical trends
clearly show a high predisposition for
borrowers to prepay early and pay
penalties. These events will also make a
100%CPY assumption inaccurate.
4) Historical analysis of Fannie Mae ACES
pools indicate that a significant number of
loans (roughly 15% of the original balance,
which represents a higher current balance
percentage) remain outstanding until the
final months of the loan. This may be due to
similar burnout activity as seen in
residential loans, or to some borrowers not
being as sophisticated as others when it
comes to financial matters. Whatever the
reasoning, the activity is present and it
contributes to the position that using
100%CPY is an inaccurate measure of
payoff probability.
Conventional wisdom in the investment community
is to analyze any opportunity to a perceived worst
case scenario, then work backwards to determine
if an acceptable risk/reward profile emerges. This
approach is a valid one so long as the downside
boundary selected is reasonable with respect to
the likelihood of occurrence.
Consider the absurd notion that a worst-case
scenario involved an asteroid destroying the Earth
tomorrow. Yes, it is a worst case, but the likelihood
is relatively remote. If investors were to consider
this event when buying securities, virtually nothing
would be a viable investment choice. Recognizing
the absurdity of the argument above, but using it as
an illustration of a point, it is easily seen that risk
and probability are not the same. If a risk exists, but

Page | 15

its probability is low, should it be called into

consideration as a reasonable downside boundary?

this writing some have been less successful than

others.

The use of 100%CPY to determine a worst-case

prepayment scenario on ACES loans is certainly a
risk, but the factors listed above, along with the
supporting data behind them, make the probability
of the event very low. As such, although current
street convention is to utilize the 100%CPY hurdle
as a potential worst-case prepayment event on
securities with prepayment-protected loans, in the
case of ACES securities, the likelihood of this event
is sufficiently remote, such that its implementation
usually results in an overstatement of risk.

Investors analyzing these instruments need to

insure that the analytics providers used to generate
cash flows on these securities are reflecting
accurate results.

Additionally though not as common, depending

upon the composition of the underlying loans and
the configuration of any given ACES pool, using
100%CPY may produce results which, in some
cases may overstate returnsan equally
problematic issue as that of being too conservative.

Analytics Accuracy
When evaluating any security, the accuracy of the
analytics systems used to generate cash flows
need to be precise. This is never truer than when
evaluating Fannie Mae ACES securities since in
addition to the standard principal and interest cash
flows, the system used needs to be able to
consider the cash flows contributed from any
penalties that are passed through to bondholders.
This has been more challenging than would be
expected.
Since, as discussed above, the DUS/ACES
programs represent a smaller subset of the Agency
CMBS world, and therefore offer fewer securities
than other programs, analytics capabilities have
been slower to catch up in applying accurate cash
flows with respect to the allocation of prepayment
penalties.
As such, it is imperative to insure that any analytics
systems used to generate return and cash flow
profiles accurately account for the additional
prepayment penalties. Many providers of analytics
have been addressing this issue, but at the time of

Page | 16

Page | 17

Sources:
FNMA, November 1, 2011 article titled Basics of Multifamily MBS
FNMA, May 1, 2012 article titled An Overview of Fannie Maes Multifamily Mortgage Business
FNMA, March 2015 MBSenger article titled Over Twenty Years of Multifamily Mortgage Financing
Through Fannie Maes Delegated Underwriting and Servicing (DUS) Program
Credit Suisse, February 21, 2013 article titled Agency CMBS Market Primer
FNMA, February 2011 article titled ASF 2011: Fannie Mae Securitization Overview
FNMA, February 2016 article titled Fannie Mae Multifamily Business Information
JRER, No.2 2003 Frank E. Nothaft and James L. Freund, article titled The Evolution of Securitization
in Multifamily Mortgage Markets and Its Effect on Lending Rates
Freddie Mac, February 2016 article titled Freddie Mac Update

Agency CMBS Summary Matrix

Ginnie Mae
Project Loan REMICs

Fannie Mae
DUS Megas,
DUS REMICs

Freddie Mac
K-Deals

Program

FHA / GNMA Project Loans

DUS MBS (Delegated

Underwriting Servicing)

Capital Markets Execution

Market Size
(Outstanding Balance)

$93 billion

$200 billion

$128 billion

Bloomberg Ticker

GNR

Mega: FN
REMIC: FNA

FREMF,
(FHMS for guaranteed
classes)

Example Deal

GNR 2015-183

FNA 2015-M17

FREMF 2015-K51

Deal Structure

Multi-tranche,
sequential pay classes

Mega: Single-tranche, pass Multi-tranche, sequential pay

through,
classes with credit
REMIC: Multi-tranche,
enhancement
sequential pay classes

IO Class

Yes

Mega: No
REMIC: Yes

Yes (multiple)

Average Deal Size

Range

$180mm - $780mm

Mega: $80mm
REMIC: $550mm

$530mm - $1.25 Bil

Mega: 25
REMIC: 135

70

Average # of Loans per 65

Deal
Loan Terms (most
popular)

Fixed rate, 35 - 40 year

Fixed-rate, 10 year balloon
maturities with full extension maturities with 30 year
amortization (10/9.5s)

Fixed-rate, 10 year balloon

maturities with 30 year
amortization

Payment Schedule

Monthly

Monthly

Monthly

Collateral / Property
Types

Mostly low, and moderate

income multifamily housing
and healthcare loans
(nursing homes and assisted
living facilities)
Proceeds can be used for
new construction or
substantial rehabilitation
projects, as well as
refinancing of existing
mortgages

Mostly standard
conventional multifamily
housing
Other eligible property
types: affordable multifamily
housing and low-income
housing tax credit, seniors
housing, manufactured
housing, coops, student
housing, military housing,
rural rental housing

Mostly standard
conventional multifamily
housing secured by
occupied, stable and
completed properties
Limited amount of agerestricted multifamily,
student housing, cooperative
housing and Section 8
housing assistance
payments (HAP) contracts

Ginnie Mae
Project Loan REMICs

Fannie Mae
DUS Megas,
DUS REMICs

Freddie Mac
K-Deals

Loan Origination
Process

Originated and
Origination and servicing
underwritten by a network of guidelines are set by Fannie
HUD-approved private
Mae in DUS program
lenders according to FHA
(Delegated Underwriting
statuary requirements
Servicing)
Loans are insured by HUD, Loans are originated,
and Ginnie Mae provides
underwritten and serviced
additional guarantee
by a network of private DUS
lenders
Loans are shared by a
DUS lender and Fannie Mae
according to a loss sharing
arrangement

Originated are
sourced/originated by
Freddie Mac's Program Plus
Seller/Servicer network of
private lenders
Loans are underwritten inhouse by Freddie Mac
through its Capital Markets
Execution (CME) program

Guarantees

Full faith and credit

guarantee of US
government

Fannie Mae guarantee

Freddie Mac guarantee

(on the senior classes)

Nature of Guarantee

Full recovery and timely

payment of principal and
interest
Prepayment penalties are
not guaranteed for IO
bondholders

Full recovery and timely

payment of principal and
interest
Yield maintenance
payments (YMP) associated
with prepayments are not
guaranteed

Timely payment of
interest to senior classes
(Classes A1, A2, and X1)
Timely payment of
principal to the classes A1
and A2 upon maturity of any
loan, and ultimate payment
of principal by final
distribution date (no
extension)
Reimbursement of any
realized losses and expenses
allocated to senior classes
upon resolution of defaulted
loans (not on the date loan
default occurs)

Call Protection

"2/8". Lockout for 2yrs,

"10/9.5" DUS MBS. Yield
Lockout and Defeasance
followed by 8yrs prepayment Maintenance for 9.5yrs,
for the term of the loan
penalty which declines 1%
open last 6 months (most
except for the last 3 months
annually from 8% to 1%.
popular)
Once the most popular call "7/6.5" DUS MBS. Yield
provision (i.e. 2005-2013).
Maintenance for 6.5yrs,
"5/8". Lockout for 5yrs,
open last 6 months
followed by 5yrs prepayment Call protection features
penalty which declines 1%
can also include defeasance,
annually from 5% to 1%.
prepayment fees and lockout
Once the most popular call Fannie Mae also places a
provision (i.e. pre-2005).
fixed, 1% penalty on
"Decreasing 10". No
prepayments which occur
lockout period. Prepayment after YMP expire, until final
penalties begin immediately, 3 months prior to balloon.
starting at 10%, which
decrease 1% annually until
gone. Currently the most
popular penalty type.

Market Pricing
Assumption

Ginnie Mae
Project Loan REMICs

Fannie Mae
DUS Megas,
DUS REMICs

15% CPJ, the conventional

Project Loan Default (PLD)
curve for default, and 15%
flat CPR for voluntary
prepayments after lockout

0% CPY: zero defaults and 0% CPR

no prepayments after
lockout
Vectored analysis; due to
passthrough of YM penalties
on prepayments, vectored
speeds need to be applied to
capture "true" value.
Historically, 0% CPR was
(and to some degree, still is)
the conventional market
pricing assumption, but
historical performance of
these securities illustrates
the need for further prepay
analysis

Sources: Ginnie Mae, Fannie Mae, Freddie Mac, CREFC, Credit Suisse, Morgan Stanley, Bloomberg

Freddie Mac
K-Deals