Fannie Mae (FNMA) DUS – An Introduction

[Pages:5]Fannie Mae (FNMA) DUS ? An Introduction

Fannie Mae is the largest government sponsored enterprise provider for the multifamily market. Their Delegated Underwriting and Servicing (DUS) program started in 1988 with securitization beginning in 1994. Today, Fannie Mae's multifamily book of business is well over $200 billion with 2011 new issuance volumes reaching $23.8 billion.

Lenders Currently, Fannie Mae has 25 approved DUS lenders that underwrite, close and service multifamily mortgage backed securities. Admissions qualifications for lenders are stringent, and they must abide by strict credit and underwriting criteria. Lenders must enter a loss sharing agreement with Fannie Mae and set aside capital reserves to comply with the loss sharing agreement. This arrangement promotes better performance overall and a high quality security for the investor.

DUS Mortgage Loans and Securities To qualify for the FNMA DUS program, properties must be existing income-producing multifamily rental or cooperatives with a minimum of five residential units. Eligible property types include apartment buildings, Co-Ops, Multifamily Affordable Housing (MAH), manufactured housing community sites, senior housing, student housing, military housing and rural rental housing (where the USDA guarantees up to 90% of any loss). The underlying fixed rate loans can have final balloon maturities between 5 and 30 years, while adjustable-rate mortgages usually have maturities of 5, 7 or 10 years. Most properties qualify for 30 year amortization schedules.

FNMA DUS mortgage-backed securities (MBS) are pools backed by eligible multifamily properties. FNMA DUS pools typically contain one loan and can vary substantially in structure. The most common FNMA DUS structure is a "10/9.5" ? a 10 year balloon with 9.5 years of yield maintenance. The second most common structure is a "7/6.5" ? a 7 year balloon with 6.5 years of yield maintenance. The securities pay principal (typically, 30 year amortizations) and interest on the 25th of each month with a 54-day delay of payment to the investor. At maturity, the investor is paid a balloon payment equal to the unpaid principal balance. In the event of a foreclosure, Fannie Mae pays the outstanding principal at par. It is important to note that Fannie Mae has never missed a scheduled payment of principal and interest on any of its MBS, single-family or multifamily.

Prepayment Protection Most FNMA DUS loans have a yield maintenance provision designed to fully compensate the investor in the event the borrower voluntarily prepays his loan. Partial prepayments are NOT permitted in the FNMA DUS program. If a borrower chooses to voluntarily prepay a FNMA DUS loan during the yield maintenance period he is assessed

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a prepayment fee1 that is designed to compensate the investor for the spread over Treasuries that would have been earned had the loan not paid off before the end of the yield maintenance period.

Involuntary prepayment from a default is the only situation that would negatively affect a FNMA DUS's cash flow because the investor is not compensated for the early prepayment, but is paid off before the intended maturity date at par. Defaults have been rare, and the Serious Delinquency Rate (60+) is only 0.46% of all outstanding loans. Once again, the superior performance of FNMA DUS is due to the underwriting criteria required of borrowers and the loss sharing that puts the FNMA DUS lender's own capital at risk on each loan they service.

Investors Almost all investors can benefit from FNMA DUS in their portfolio. Insurance companies and pension funds can gain from the products stable cash flows that permit these institutions to match future liabilities. Money managers like the positive convexity of multifamily MBS; it helps mitigate the negative convexity of single-family MBS. Traditional bond investors like the strong prepayment protection and the higher yields versus similar duration high-grade corporate and agency bonds. For depository institutions, FNMA DUS securities have the same 20% risk weighting, as do singlefamily FNMA MBS. Finally, for state and local governments that must abide by restrictions in their investment guidelines, FNMA DUS securities offer credit quality, prepayment stability and a variety of maturities.

For financial institutions and pension funds looking to maintain a barbell position, FNMA DUS securities provide a great investment alternative for the longer end of the yield curve. Examples of longer duration structures include 15/14.5, 20/19.5, and 30/15. For those investors who require shorter maturities, 5 and 7 year structures are available along with numerous outstanding secondary issues that should fit these same needs.

In addition, for those portfolio managers that foresee a margin squeeze for their institution in the coming years as rates stay low or flat, FNMA DUS securities offer an opportunity to lock in attractive spreads now with limited extension risk. As shown the chart below, FNMA DUS securities have historically maintained an attractive spread to treasuries.

1 The prepayment fee is the greater of 1% of the unpaid principal balance, or the unpaid balance times the present value of the difference between the mortgage note rate and either the yield on a pre-specified Treasury note or an applicable Treasury CMT (Constant Maturity Treasury). For all loans originated after September 2009, the calculations will be with CMT. The FNMA DUS investor would receive the portion of the yield maintenance penalty paid, which is calculated using the pass thru rate on the security rather than the mortgage note rate.

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Community Reinvestment Act (CRA) For depository institutions, FNMA DUS securities may qualify for CRA credits. Many financial institutions are investors in FNMA DUS where the underlying collateral property has either restricted rents to low-to-moderate income individuals or is in a lowto-moderate income census tract. The properties could be either Section 8 or Low Income Housing Tax Credits, whereby partial equity in the loan transaction has come from the sale of Low Income Housing Tax Credits that were issued by the state. To comply with these Tax Credits borrowers must restrict rents in their properties to low and/or moderate individuals who earn 60% of the area median income or less. In either case, the Compliance Officer at the investing institution should make the decision as to whether an investment in FNMA DUS meets the CRA needs of his bank.

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Conclusion To conclude, FNMA DUS securities can be a valuable and attractive addition to any investment portfolio. Some of the features highlighted in this discussion are as follows:

? Aaa/AA+ rated credit strength due to Fannie Mae's guarantee of timely payment of principal and interest

? Pools are backed by loans on existing, income-producing multifamily properties ? FNMA DUS lenders required to share risk of loss if default occurs ? Limited prepayment and extension risk ? Stable monthly cash flows that are easy to model on Bloomberg ? Wide variety of maturity and amortization options (5-30 years) ? Lower spread volatility relative to other products ? Greater yield versus similar duration agencies and corporates ? Targeted affordable properties may be suitable CRA investments for banks ? Liquidity enhanced from large number of dealers involved in market making

Duncan-Williams, Inc. (DW) has purchased almost $20 billion in DUS since 2009 making us the largest investor outside Fannie Mae. We have been an active market-maker in the FNMA DUS market since 1998 and have established the DW name within the FNMA DUS community. DW supports both the origination and distribution of the product and makes a market for all 25 approved lenders. For more information call your Duncan Williams representative today.

Sources: FNMA November 1, 2011 article titled "Basics of Multifamily MBS" FNMA September 2011 MBSenger article titled "Over Twenty Years of Multifamily Mortgage Financing Through Fannie Mae's Delegated Underwriting and Servicing (DUS) Program"

Geetika Bansal Senior Market Analyst Fixed Income Strategies & Services.

Catherine Folk Market Analyst Fixed Income Strategies & Services

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Chad McKeithen Managing Director 901.260.6887 chad.mckeithen@

Chris Klass Senior Market Analyst 901.260.6810 cklass@

OFFICES Akron Atlanta Birmingham Charlotte Cleveland Chicago Gainesville

Geetika Bansal Senior Market Analyst 901.435.4016 gbansal@

Catherine Folk Market Analyst 901.435.4162 Catherine.folk@

Houston Jackson Memphis New York Philadelphia Tampa

Disclaimer: This material has been prepared by Duncan-Williams, Inc., member FINRA/SIPC (Duncan-Williams"), from information sources believed to be reliable. Duncan-Williams expressly disclaims any and all liability which may be based on such information, errors therein or omissions there from, or in any other written or oral communication related thereto. This material is for your information only and should not be construed as investment advice or as any recommendation of a transaction. Neither Duncan-Williams nor any of its representatives is soliciting any action based upon this material. Specifically, this material is not, and is not to be construed as, an offer to buy or sell any security or other financial instrument referred to herein.

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