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New asset class? Arch issuing $368M PMI-linked notes

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Arch Mortgage Insurance is taking a page from Fannie and Freddie’s book.

Like the two government-sponsored enterprises, Arch is looking to offload some of its exposure to potential defaults on residential mortgages to capital markets investors. Rather than purchase traditional reinsurance, it’s offering $368.11 million of bonds whose performance is linked to that of a pool of mortgages that the company insures. Should losses on the mortgages reach a predetermined level, investors will forfeit some of their principal.

That’s similar to programs that Fannie Mae and Freddie Mac have used since 2013 to offload the risk of losses on mortgages that they insure. In Arch’s case, however, what’s being reinsured is no more than 20% of the balance of the mortgages. To qualify for a conforming mortgage, borrowers must either make a 20% down payment or purchase a private policy that reimburses the servicer a portion of the difference between the outstanding balance of the defaulted mortgage and what's recovered from the real estate owned property sale. The GSEs insure the remaining balance of a loan.

The underlying balance of mortgage loans covered by the policies is $29.30 billion, but the mortgage-insurance policy coverage amount is $7.36 billion, according to Morningstar Credit Ratings.

Most of the loans being reinsured in this transaction, dubbed Bellemeade Re 2017-1, meet criteria to be acquired and reinsured by Fannie or Freddie. So, in theory, at least, investors purchasing notes could be acquiring exposure to some of the same loans reinsured by Fannie’s Connecticut Avenue Securities or Freddie’s Structured Agency Credit Risk deals.

This Arch's first rated transaction from the Bellemeade platform, according to Morningstar. The reinsurer has completed two unrated deals, one in 2016 and one in 2015.

Three classes of floating-rate notes are on offer: $195.1 million of Class M-1 notes with a preliminary BBB rating; $154.6 million of Class M-2 notes rated BB-; and $18.4 million of Class B-1 notes rated B+.

The most subordinated notes to be issued, the $165.6 million Class B-2 tranche, represents the first-loss position. Arch’s reinsurance subsidiaries will retain part of the tranche equal to at least 5% of issued securities.

The final scheduled payment date for all of the notes is October 2027.

The reference pool of mortgages are amortizing, fixed- and variable-rate, first-lien loans that have never been reported as in default. None has ever been modified. There are no interest-only loans and all loans fully document borrower income. Borrowers have a weighted average FICO score of 744 and weighted average current loan-to-value ratio of 91.79%.

The pool is geographically diverse. The largest state concentration is California, with approximately 8% of the balance.

No actions have been taken regarding mortgages secured by properties in areas affected by Hurricanes Harvey and Irma or the areas in California affected by wildfires. The master policies covering these mortgages contain clauses that generally exclude claims arising because of physical damage of the property, subject to the terms of the individual policies.

Morningstar’s presale report cites as a risk to the deal Arch’s ongoing integration of the operations of United Guaranty, which it said has led to more turnover among managers and employees as the company eliminates overlapping positions and relocates jobs. This could cause disruptions to business operations.

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