Fannie Mae DUS – The other side of the transaction.
Someone recently sent me a copy of a great research piece by Barclays Capital. This is an analysis of the investing in Fannie Mae DUS loans titled DUS: A Primer. Its a basic analysis of the DUS program from the bond investors perspective. It clearly outlines the program, how it works and why its beneficial to the investor. After reading this I have a much better perspective as to how the investor sees the loans and what they are looking for in the investment.
Since the bonds have a Fannie guarantee these investors don’t care at all about the real estate risk of the loan. They rely on Fannie and the DUS lender and their guarantees. The main concerns are prepay speed (which is protected by the prepayment premium), geographic location of the property and liquidity of the bond with that liquidity being the biggest driver of the price. That clearly explains why small loan Fannie loans price higher than traditional DUS. It also partially explains why Freddie CME pricing may be lower than DUS given the securities are larger and therefore theoretically more liquid.
The interesting thing about the articel is it seems to beleive that DUS bonds are cheep. Especially when compared to other Fannie debt or mortgage backed securities. If this is ture them its possible the Fannie speads will reduce over time. However, don’t get too excited becuase in the bond world a few Bps mean a lot and it seems that they are talking about 10 Bps or so in change which while nice is not a game changer in hte interest rate for a property owner.
One of the reasons they look cheep is due the structure. On a dollar value, you really don’t compare them to traditional agency mbs pass-thru securities. Due to the prepayment premiums/penalties and longer amortization of principal payments on shorter finals, the bonds compare more closely to balloon structures and agency bullet structures..hence the spread to the US swaps curve vs the standard interpolated treasury curve. The market can swing based on supply/demand issues, but general 5-7yrs are currently trading around 40 to 60bps above the swaps curve with is roughly the same spread to agency bullets.
Unlike agency debentures, you still receive monthly payments of MOSTLY interest and less principal. After the initial yield maintenance period these borrowers in most cases tend to refinance the deal, especially in lower interest rate environments. If its financially feasible they could choose a faster amortization of principal in the form of early prepayments of principal. However, that is usually not the case due to the STIFF points of premium prepay penalties…which by the way pass thru to the holder of the securities.
If anything, I believe they offer a more stable cash flow than traditional residential single family mortgages. If one invests in high grade AAA or double AA corporate credits and or agency debentures, FNMA DUS bonds offer a significant spread with the same AAA rating and pledging as other agency securities.