PennyMac Mortgage Investment Trust is entering into an unusual transaction that provides Fannie Mae with mortgage reinsurance — but only on loans the real estate investment trust itself has underwritten.
It’s preparing an offering of bonds through Fannie’s L Street Securities program, which offloads a portion of the credit risk on a pool of $22.25 billion of mortgages that PennyMac originated between May 1, 2016 and May 1, 2018. L Street Securities is modeled on Connecticut Avenue Securities, Fannie Mae’s benchmark credit risk transfer program which provides reinsurance on a pool of recently securitized mortgages underwritten by multiple lenders. Fannie has issued some $34 billion of Connecticut Avenue Securities to a wide variety of capital markets investors since 2013.
Rather than sell bonds to third-party investors, however, PennyMac will purchase bonds issued by L Street Securities 2017-1 PM itself. (In a description of the program posted on its website, Fannie Mae says that L Street securities are “typically retained by the lender so that they can hold the credit risk on their loans in certificated form.”)
This isn’t PennyMac’s first offering of L Street Securities, though it is the largest; a person familiar with the transaction says that the REIT has completed three others. But it is the first that will be rated, according to Fitch Ratings.
A credit rating could serve two purposes: It could make the securities easier to sell at some future date; it could also make it easier to borrow against the securities, using them as collateral for sale-and-repurchase agreements, loans or bonds.
PennyMac has used other mortgage-related assets as collateral in the past. For example, in April it issued $450 million of five-year term notes secured by rights to service mortgages insured by Fannie Mae.
The latest L Street transactions is part of the REIT’s stated strategy of moving out of opportunistic investments in distressed mortgages and into more programmatic kinds of mortgage investments such as credit risk transfer securities and mortgage servicing rights.
As of June 30, approximately 15% of the PennyMac’s equity was allocated to distressed loan investments compared with 50% two years earlier, while credit risk transfer and mortgage servicing rights accounted for 67% of equity allocation, the company disclosed in its second quarter financial reports.
Here’s how the L Street transaction works:
It consists of five tranches of notes. The $21.5 million senior tranche of securities is for reference purposes only; the notes are not issued or sold, according to Fitch. PennyMac will purchase two rated mezzanine tranches and two unrated subordinate tranches totaling $778 million. Together these four tranches represent the first 3.5% of losses on the principal of the mortgages in the reference pool.
Fitch expects to assign a BBB to the $111.3 million M1 tranche, which benefits from 3% credit enhancement and will initially pay interest of 4.74%, and a B to the $445.1 million M2 tranche, which benefits from 1% credit enhancement and pays interest of 5.74%.
The two unrated tranches, which will absorb first 1% of losses in the reference pool, both pay 8.74%
All of the notes are Libor-based floaters and have a final maturity of 10 years.
Proceeds from the sale of the notes will be deposited into a cash collateral account and will be used first to reimburse Fannie Mae for any losses on the loans in the reference pool (up to 3.5% of the original principal balance) and then to fund the principal and interest payments due on the securities.
The government-sponsored enterprise is on the hook for any losses exceeding 3.5%, assuming it has not offloaded this risk through another type of credit risk transfer transaction.
PennyMac has already paid guarantee fees on the mortgages in the reference pool. Fannie Mae will now place a portion of these fees (representing a reduced g-fee) in an established interest account and use them to help pay interest to the class M securities.
Overall, the reference pool’s collateral characteristics are similar to recent Connecticut Avenue Securities transactions, according to Fitch. The weighed average FICO score of borrowers is 747; the mark-to-market combined loan to value ratio is 77.7%, which Fitch describes as a "moderate" amount of leverage; 73% of the reference pool are purchase loans, which are considered less likely to default than refinance loans; and almost all were originated through PennyMac correspondent lenders' retail channels and have a lower default risk than those originated through a broker, correspondent or wholesale channel.
