The owners of a Virginia Beach apartment complex have defaulted on their mortgage, threatening a $27 million refunding bond deal only two years after the bonds were sold.

Standing between bondholders and an extraordinary call, however, is the Federal National Mortgage Association, which issued a passthrough certificate guaranteeing the mortgage. In fact, Fannie Mae now owns the 862-unit Regency Apartments complex after failing to find an buyer for it during a foreclosure sale on Aug. 27.

The Portsmouth, Va., Redevelopment and Housing Authority's $27.03 million Series 1989 refunding revenue bond issue is supported by the passthrough certificate and will remain safe unless Fannie Mae chooses to withdraw the certificate, according to Pat Welling, corporate trust officer at Sovran Bank, trustee on the deal.

In that event, the bonds will be called, and investors will receive their principal back after collecting only five 7% coupons. Ms. Welling emphasized the bonds are not in default and Fannie Mae's possession of the property does nor constitute a technical default under the bond indenture.

Lynn Hawkins, manager of multifamily asset management in Fannie Mae's Southeast regional office, said the project owners depleted Regency's debt service reserves, which were funded annually, since early 1990. "The basic reason they gave us was that the market changed adversely, and occupancy dropped to such a state that the overall operations were untenable," Ms. Hawkins said.

Fannie Mae has three options at this point, Ms. Hawkins said. "We can administer [the project] ourselves and keep the bonds alive; we can sell the property and still maintain the bonds; and we can cause the bonds to collapse" by withdrawing the certificate, she said.

Standard & Poor's Corp. rates the bonds AAA, based on the Fannie Mae certificate.

The attorneys for Regency Apartments Associates, Norfolk-based Kaufman and Canoles, were unavailable for comment.

The project itself is currently 95% occupied, according to Pat Cole, manager of leasing and marketing at Regency's management company, Insignia Management Group. Ms. Cole said the occupancy levels represent a remarkable turnaround from the 73% level hit in April.

"The market is not soft," Ms. Cole said. "This is a military town, and after the war broke out -- this being the largest project in the area -- we fell to 73% occupied in April."

Reflecting pride in the turnaround, Ms. Cole spelled out how a staff of 40 to 50 moved 109 families into the complex during the course of one month, and the maintenance crews prepared 138 apartments for occupancy in the same period.

"This one of the best and most organized systems I have ever seen," she said. "My understanding is the biggest problem here is the debt service."

The Regency Apartments project is the latest in a growing list of deals that are chipping away at the federal government's housing guarantee budgets. The Federal Housing Administration and the Government National Mortgage Association also provide backing to tax-exempt housing issues through mortgage enhancement.

The FHA program is the largest and most vulnerable to the nation's sweeping real estate recession. In the past 20 months, at least nine FHA-backed municipal deals totaling about $350 million have undergone mortgage defaults. FHA has also paid at least $170 million in defaulted mortgage claims.

But Fannie Mae deals open up a sizeable area of liability for the federal government. Since the first Fannie Mae-backed municipal issue in 1984, the agency has backed 199 issues totaling $4.33 billion, according to Securities Data Co./Bond Buyer.

In the Regency Apartments' case, ironically, the federal government's own policies may have triggered the mortgage default. The project is occupied primarily by naval personnel stationed in the Norfolk area, and cutbacks in the government's military budget are resulting in fewer renters in the Regency project.

In fact, the predominance of navy families creates an unusual anomaly. Although the complex is required to have only 20% of its units rented to "low-income" residents -- those making less than $29,500 per year -- more than 70% of the units fit that description, according to Marcia McVay, development coordinator at Portsmouth Redevelopment and Housing.

"The majority of folks are naval personnel," Ms. McVay said. "They get a housing allowance, commissary privileges, and free medical benefits. They are eligible from the perspective of the tax statements, but its not too difficult for them to subsist rather well."

Ms. McVay added that the reduction in military personnel, first with troop deployments to the Persian Gulf area and then with outright cuts, has devastated the area's rental market. "They can't give those apartments away," she said. "They're offering free month's rent and so forth."

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