The Ohio Housing Finance Agency priced a taxable refunding issue last week with a put option structure more commonly found in the mortgage-backed derivatives market.
The structure, designed by Goldman, Sachs & Co., helps the agency cope with the unpredictability created by a refinancing wave that has hit the mortgages backing the agency's outstanding bonds.
In addition, the structure allows the agency to capture a spread of about 5% per year between the rate it pays on the $86 million issue and the rate it receives on outstanding mortgages, according to participants in the deal.
Trying to match assets and liabilities in the unpredictable mortgage-backed securities market can create headaches for issuers and even the most sophisticated investors. Several major securities firms, for example, misjudged the mortgage derivatives market over the past year, leading to losses of hundreds of millions of dollars.
In the case of the Ohio agency, it needed to refinance bonds issued in 1983 that do not mature until 2014 and are backed by equally long-term mortgage loans.
But the long maturity of the loans is an illusion. With rates falling, homeowners have already been refinancing the mortgages, which carry 10% rates, at a rapid pace. As mortgages are refinanced, the agency is required to call a proportionate amount of bonds.
Over $300 million of the agency's underlying mortgages have been refinanced since 1983, leaving about $100 million of loans outstanding by Aug. 31, 1993. The agency issued two series of bonds backed by mortgage loans in 1983, series A and B, totaling $410 million.
The refinancings led to the calling of an equivalent amount of bonds backed by the mortgages, leaving just $84 million of one series outstanding and $26 of the second series by August 31, 1993. The refunding will be applied to all of the Series A bonds outstanding currently and $12 million of the Series B bonds.
The agency saw an opportunity to capitalize on market spreads through a refunding, since it will continue to receive high coupon payments from mortgage holders at a time when it can sell new debt at rates nearly 500 basis points lower.
But mortgage holders are expected to continue refinancing their high-cost mortgages, leaving the agency with an expected window of only two years in which to capitalize on the spread advantage.
Ohio housing officials describe the loans as "a wasting asset." The $86 million pool of loans backing the refunding issue has an expected average life of under two years.
Since most of the mortgages will be, refinanced in the next two years, the agency hoped to issue two-year debt. If the agency issued longer-term debt, it would have sacrificed some of the spread by paying long-term rates. And the long-term bonds would likely be retired in two years anyway as the underlying mortgages are refinanced.
If the agency issued two-year bonds, and if all went according to plan, not many bonds would be left outstanding in 1995.
But the rating agencies were worried. What if interest rates rose dramatically? What if homeowners did not refinance at the expected rate?
In that case, the bonds would come due after two years and the agency would be holding the underlying long-term mortgage loans, with no ready cash to pay bondholders their principal. The agency's only option would be to try to sell the mortgages in the open market.
"They needed to have the ability to liquidate the mortgages after two years," said Christopher Martin, head of the public finance asset-backed group at Moody's Investors Service. Without the put option or other enhancement, he said, "The risk was to great that the market value of the mortgages might not cover their liability."
Moody's analysts also feared that the agency might not be able quickly to find a buyer for the mortgages. "The timing issue also concerned us," Martin said.
To assuage the rating agencies, the housing agency included a put agreement, provided by Goldman Sachs' mortgage company subsidiary. The put obligates Goldman Sachs to purchase unrefinanced mortgage loans from the agency in two years at a pre-set price if needed.
The two-year put is considered long, even in the complex world of mortgage-backed derivatives. Calculating the value of the put option requires making assumptions about the level and volatility of future interest rates, as well as making predictions about the behavior of homeowners.
The housing agency also included a mortgage insurance policy covering defaults on the underlying loans from GE Mortgage Insurance Co.
In the end, the agency received Moody's A1 long-term rating and VMIG-1 short-term rating on the issue. Standard & Poor's Corp. rated the issue SP-1, but did not assign a long-term rating.
Goldman priced the deal to yield 4.35%, a spread of 51 basis points more than the two-year Treasury bond.
"The deal was a home run for the agency," said Dick Everhart, the agency's executive director. "The savings realized from this refunding enhances our ability to provide affordable housing in Ohio."
After two years, the agency might not exercise the put even if some bonds are still outstanding. If interest rates remain low and some mortgage loans have not been refinanced, the agency could remarket the bonds for another short period. The agency could try to obtain another put agreement in that case, since the Goldman put expires in two years.
The agency could also refund the bonds with a tax-exempt refunding. Even though the current deal is taxable, the tax-exempt status could be resurrected on a future deal, Goldman officials said.
Also, the agency could sell unrefinanced loans on the open market, perhaps garnering a better price than it would receive from Goldman under the put.
The huge spread available to the agency, representing the difference between the 10% coming in from the loans and the 4.35% it is paying on its new bonds, would be limited if it sold a tax-exempt issue. Tax laws limit the agency's spread on tax-exempt deals to 1.125%, or about one-fifth of the spread it can collect on a taxable transaction.
Even though the agency's cost of funds would have been even lower than 4.35% on a tax-exempt issue, the agency would have been limited to a spread of 1.125%.
The deal involved an unusual effort from Goldman. Generally, the firm's municipal finance department has little interaction with the arcane world of mortgage-backed derivatives.
But the Ohio deal was a "joint venture," in the words of one Goldman official, between the municipal and mortgage departments.
"The tax-exempt housing market and the taxable mortgage securities markets have largely operated in separate worlds, utilizing different structures and catering to different investors," said Adam Sherman, vice president in Goldman's municipal department.
The Ohio deal required "close coordination" between the two areas, Sherman said.