Mortgage reserve fund
An amount equal to two months of principal and
interest on the mortgage covers liquidity shortfalls
immediately following a mortgage default.
Standard & Poor’s assumes that, although a mort-
gagor’s payment is due on the first day of the
month, the payment is not received until the last
day of that month. In addition, trustees are reluc-
tant to file an insurance claim at this time, because
FHA regulations allow an additional 30-day grace
period for the mortgagor to make payments due on
the mortgage note.
Demonstration of a 30-day lag in the cash flows,
plus a reserve equal to one month’s principal and
interest on the mortgage note, can cover the two
months’ liquidity requirement. Showing receipt of
one less mortgage payment between the full funding
of the mortgage note and the next bond payment
date proves the cash flow lag. If the cash flows
demonstrate sufficient revenues to pay debt service,
no further credit support is necessary to fund the
lag. However, if a shortfall exists, additional cover-
age needs to be in place at bond closing. The sec-
ond month may be funded from bond proceeds,
cash, LOC, or other acceptable credit support.
In absence of a lag, the mortgage reserve fund
should contain two months’ principal and interest
on the note. Bond proceeds can fund one of the
months, while the second should come from cash,
LOC, or other acceptable credit support. The
financing documents should clearly provide for use
and replenishment of this reserve, because FHA
insurance proceeds exclude the payment of one
month’s interest on the mortgage note.
Credit Shortfalls
Unlike liquidity reserves, credit shortfalls cannot be
recouped. Therefore, funding for credit shortfalls
should come from acceptable sources other than
bond proceeds. Additionally, combined trust assets
always should exceed bonds outstanding by the
total amount of credit shortfalls.
The 1% assignment fee
A program shortfall can occur on FHA-insured mort-
gages in which the FHA pays out 99% of the out-
standing mortgage balance. In such cases, at bond
closing, the mortgagor or other third party contributes
the “1% assignment fee”—that is, the remaining 1%
portion of the mortgage to cover this shortfall.
Nonasset bonds
A structural shortfall occurs when the initial
amount of bonds outstanding exceeds the outstand-
ing mortgage amount and other trust estate funds
or investments eligible for inclusion as assets. This
situation results in nonasset bonds without suffi-
cient collateral support.
Negative arbitrage
Resulting from interest-rate spreads, negative arbi-
trage is a common problem in new construction or
substantial rehabilitation transactions. This occurs
when escrowed monies earn interest at a rate lower
than the mortgage and bond accrual rates. Most
often, this results in a shortfall until the construc-
tion fund has been drawn down in full and com-
mencement of amortization on the mortgage note
has begun. To quantify the amount of the shortfall,
Standard & Poor’s assumes that 90% of the funds
are drawn down one month prior to commence-
ment of amortization. The remaining 10% are
drawn down 18 months later.
Upon commencement of amortization, the cash
flows should reflect a reduced mortgage payment
until the 10% draw. The principal component
remains the same as if the full mortgage amount
were originated. The difference comes in that the
borrower only owes interest on the 90% drawn
from the construction fund. This draw scenario
allows for the eventuality where commencement of
amortization occurs prior to final endorsement of
the mortgage note by FHA. To prevent a greater
shortfall, it is prudent to have the construction fund
investment agreement expiring no sooner than 18
months after commencement of amortization.
Another situation where negative arbitrage
occurs is while the trustee holds funds for redemp-
tion during the required redemption notice period.
During this time, shortfalls could occur if the funds
cannot be invested at the bond accrual rate.
Standard & Poor’s will use the minimum notice
period in the bond documents to calculate reinvest-
ment risk coverage. This shortfall should be provid-
ed at bond closing and maintained for the life of
the issue.
Cash and LOCs associated with mortgage loans
According to HUD regulations, cash or LOCs held
by the mortgagee may be deducted from the insur-
ance claim. These items have the potential to
become security for the bonds. Depending on dura-
tion, purpose, and amount, they may be subject to
the same requirements as the bond-related credit
enhancements discussed above. In addition, docu-
ments must clearly condition release of these items
only with appropriate FHA approvals.Structural Considerations
In FHA transactions, there are several structural
considerations that can have a substantial impact
on the credit quality of the transaction. TheseFHA Insured Multifamily Mortgageshttp://www.standardandpoors.com 251