The Massachusetts Housing Finance Agency took a big step toward clearing up some troubled credits this week through an innovative refunding of rental housing properties.

Proceeds from Wednesday's $327.8 million refunding, 1994 Series A, will be used to restructure 32 defaulted mortgages on 27 low-income housing developments.

The purpose of the refunding was to free the Housing Finance Agency from having to supplement state funding for the troubled housing projects.

The projects were conceived during the mid-1980s as part of the commonwealth's State Housing Assistance for Rental Production program. To be eligible for assistance, builders agreed to set aside at least 25% of a new development for low-income housing. The state would then provide money at a set rate for a fixed period to help the developers recoup the lost rent.

Problems arose with the projects in the late 1980s and early 1990s because rent payments that the projects were able to fetch fell far below projections when the real estate boom in Massachusetts crashed.

"The program was founded in the context of an optimistic, hyper-inflated real estate market," said Henry Lanier, managing director at Lehman Brothers, the senior manager on the refunding. "Many [SHARP projects] ran into the reality of real estate 'recession, which hit no place more strongly than Massachusetts."

The program was conceived during the so-called Massachusetts Miracle in the mid- to late 1980s, with underlying mortgages that are high compared to today's rates, ranging from 8% to 10.34%.

Compounding the problem, the subsidies were structured to decline over time, based on the theory that housing rented at prevailing market rates would eventually be able to "internally subsidize the low-income housing," Lanier said.

In the late 1980s and early 1990s, with the moneys from the program proving insufficient and the state legislature scaling back its subsidies, the Housing Finance Agency stepped in and began subsidizing some of the projects from its own funds.

The assistance was a major cash drain on the agency. When it became apparent that many of the projects were entering into default or were expected to do so soon, the agency began the process that led to this week's refunding. Twenty-four of the projects being refunded in the 1994 Series A offering have received some assistance under the program.

The bonds sold this week fetched a top yield of 6.75% in 2028 and will replace 13 outstanding issues sold separately from 1986 to 1990 with yields ranging from 8% to 8.5%.

Insurance from AMBAC Indemnity Corp. garnered triple-A ratings from Moody's Investors Service, Standard & Poor's Corp., and Fitch Investors Service for the bonds, which are subject to the alternative minimum tax.

A moral obligation from the state to cover any shortfall in the debt service reserve fund provides the main source of security on the offering, which AMBAC officials said was a chief reason the bonds qualified for insurance. A $30 million debt service reserve fund provided additional backing for the underlying credit.

The offering was heavily weighted in serials maturing from 1995 to 2009, with term bonds in 2014, 2019, 2024, and 2028.

The 2024 maturity, which made up $15 million of the sale, was structured as a super sinker, a first for a multifamily deal, according to members of Lehman Brothers' underwriting team. Housing bond analysts were unable to confirm that it was the first, but one said that a supersinker is "extremely innovative" on a multifamily bond.

A super-sinker is a term bond designed to be called before any other term maturity. The super sinkers in the agency's deal have an expected average life of six years, and were priced to yield 6.30% in 2024.

"It is an innovative way of protecting bondholders from indiscriminate calls," Lanier said. "We knew that investors in multifamily housing bonds don't like to anticipate calls in the first year of a program. Unlike single-family bonds, multifamilies are supposed to stay out there. By introduction of the super-sinker, we have insured that that will be the case."

A member of the underwriting syndicate said the super-sinker maturity was purchased by a single institutional investor, but he declined to name the buyer.

"We got a lower rate due to the shorter average life," Lanier said. "The super-sinker was in there in part to save [the agency] some money."

Adding to the uniqueness of the offering, the super-sinker is going to be repaid from surplus revenues generated by the refunding, instead of a typical prepayment schedule.

The proceeds are projected to come from "the gap between the rate on the mortgages and the rate on the bonds," Lanier said.

The "gap" is created by another quirk in the transaction: The restructuring will lower debt service on the bonds, but was not designed to change the mortgage rates on the underlying properties.

"Most of that excess spread is in fact being absorbed by serial bonds, but even with the front-loading principal structure, there are still surplus revenues," Lanier said. "The excess revenues are pledged to call bonds, with the 2004 maturity directed to be called first."

Maintaining the mortgages at current levels seemingly offers no benefit to the property owners, but Paul K. Burbine, financial director of the Massachusetts Housing Finance Agency, said the restructuring will free up funds, allowing the agency to work out the troubled loans instead of forcing a foreclosure.

"We have an agreement to enter into an agreement to enter into workout with the developments in order to make them work," Burbine said. "We tend to not foreclose on [projects] but to work them out [and] maintain low-income housing, which is what we're supposed to be doing."

Because the subsidies "substantially alter the mortgage rate" on the underlying loans, the agency avoided arbitrage violations, which might otherwise have resulted from the spread created by lowering the bond payments and maintaining the mortgage rates at a constant level, Lanier said.

The transaction was structured so "the nominal rate of the mortgages remains constant while staying within the yield constraints of the arbitrage regulation," he said.

Other analysts said that maintaining the mortgage rates on the underlying properties raises the specter of further defaults. The prospect is heightened by the fact that subsidies undfer the program have a maximum limit of 15 years.

Lanier noted that the agency disclosed in the preliminary offering statement that it expects "some projects to have difficulty meeting mortgage obligations after their [SHARP] contracts have been exhausted."

However, the refinancing is structured so that "net operating income can pay off the bonds even if isolated developments might still have some trouble meeting mortgage obligations after the subsidy contract period is over," he said. "The refinancing has to be looked at on a portfolio basis."

The restructuring is designed so the bonds are overcollateralized from the onset of the financing, with the level of overcollateralization expected to increase over time.

Following the refinancing, the agency has $12.3 million more assets than liabilities for a parity ratio of 103.8, Lanier said. After 10 years, assets are projected to decline to $279.8 million with $195.3 million of bonds outstanding, he said, translating into overcollateralization of $84 million, or a parity ratio of 143.

"We've built in a huge amount of overcollateralization so individual ]developers] don't have to pay us their full mortgage obligations in order for us to meet our liabilities," Lanier said.

In addition, "by the time the SHARP subsidies are gone, there are a lot of bonds in this financing that will have been matured and retired," said James B.G. Hearty, senior vice president at Lehman, adding that a rebound in the real estate markets is expected before the subsidies expire.

One housing bond analyst suggested that the agency might also be planning a "differed mortgage rate cut," lowering mortgages on certain properties later in the life of the transaction.

"There could be some sort of workout that resulted in lower mortgages," Lanier said, "but only if it doesn't compromise the financial integrity of the bond issue."

Because of the byzantine nature of the transaction and the fact that the underlying credit consisted of defaulted mortgages on low-income housing projects, the issue was "more difficult to sell than most," said a member of the underwriting team, which included 14 other firms in addition to Lehman Brothers.

"There was mostly intermediate bond fund interest and solid retail demand," the trader said, noting that "we would have seen more" interest if not for a glut of short-term Massachusetts paper and the fact that many accounts are at their limits for AMT bonds.

However, thanks to the firm tone of the market after the Federal Reserve's tightening on Tuesday, there was brisk business reported on the sale.

"In a rocky market it would have been a much more difficult sell," the trader said. "But it was a very successful sale and the marketing process benefited greatly from postponing it from Tuesday to Wednesday so we could get the benefit of the Fed's move."

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