Housing250 Standard & Poor’s Public Finance Criteria 2007
T
he security for Federal Housing Administration
(FHA)-insured multifamily mortgage-backed
issues consists of several components, primarily the
insured mortgage note, investments, and reserves.
Standard & Poor’s Ratings Services assumes that a
mortgage default may occur at any time during the
term of the bonds. Since the FHA’s regulations and
practices do not provide for immediate claims pay-
ments, reserves need to be available to pay the
bonds until the claim is paid in full.
The FHA has given Standard & Poor’s assur-
ances that HUD, of which the agency is a part, pro-
vides priority processing for insurance claims
involving projects financed with rated bonds. The
FHA permits processing to go forward when work-
outs are being pursued, a concept often referred to
as “dual processing,” which is necessary to ensure
reserve sufficiency in the event that the workout is
unsuccessful. Moreover, the agency has indicated
that it will act to process claims expeditiously so
that final payment is received within a reasonable
time frame, assuming that the trustee acts expedi-
tiously during the assignment process. Standard &
Poor’s sets its reserve fund guidelines based on these
representations and an assessment of the potential
for delay based on actual defaults. These factors, as
well as demonstrated coverage of other inherent
program shortfalls defined below, enable
Standard & Poor’s to assign ratings as high as
‘AAA’ to these issues.
Standard & Poor’s criteria for FHA-insured mort-
gages includes multifamily, hospital and nursing home
programs, as well as the HFA risk sharing program.Supports And Shortfalls
Standard & Poor’s looks for coverage of the poten-
tial shortfalls cited below at bond closing to protect
bondholders in case of a mortgage default and a
loss of interest earnings. Credit enhancement mech-
anisms include cash, third-party supports, and other
structuring mechanisms.Liquidity Reserves
Reserves provide the liquidity needed to offset
potential interruptions in debt service in the event
that a mortgagor defaults. Bond proceeds can fund
these reserves, since interest paid on mortgage
insurance benefits should be sufficient to replenish
the reserves.Debt service reserve funds
Standard & Poor’s has concluded that, in cash pay-
out programs, a debt service reserve fund equal to
eight months’ maximum bond debt service should
be sufficient, based on the following:
■Mortgage insurance is paid in two installments.
■In a worst-case scenario where the default occurs
prior to final endorsement, the first portion of
70% of mortgage insurance is paid within six
months of the date the notices of default and
intention and election to assign are sent. HUD
pays this amount following the recording of the
assignment of the mortgage loan to the FHA.
Bonds should be redeemed with this insurance
payment on the earliest practicable date.
■Standard & Poor’s assumes that the claim’s
remaining 30% may not be received until the six
months after the first payment. This is because
the trustee is required to obtain information and
documentation from hazard insurers, the mort-
gagor, the servicer, and other third parties, and
reliance on these third parties can cause delays.
A debt service reserve fund (DSRF) equal to
maximum annual bond debt service is needed in
debenture pay issues where the insurance claim
is paid in one installment. Debentures are
assumed to be received within one year of the
notice of default.
Bond proceeds typically fund the debt service
reserve fund, although other methods, such as let-
ters of credit (LOCs) issued by banks rated as high
as the bonds, or cash, are sometimes used. The
investment of DSRFs in investment agreements for
the life of the issue eliminates market risk. When
the reserve is funded with bond proceeds, if the
reserve is called on, the expended portion is no
longer earning expected investment income.
Depending on when the drawdown occurs,
Standard & Poor’s has found that a shortfall may
be created. The shortfall may be offset by the
interest component of the FHA insurance pro-
ceeds. A sufficiently high debenture interest rate,
relative to the owner’s mortgage coupon, can miti-
gate the lost earnings on the debt service reserve
fund. Any shortfall that arises needs to be covered
at the time of the rating.