Recent years have shown that interest rates play a far greater role in the municipal housing sector than does the strength of the economy, and such is the case in 2014, with the low-interest-rate environment likely to cap bond issuance despite decreasing unemployment and slightly increasing mortgage rates.

Standard & Poor’s Ratings Services predicts that the 30-year fixed mortgage rate will average 4.6% and possibly reach 5.4%, but that even a rate in the high end of this range would result in diminished mortgage revenue bond (MRB) production compared with past years (see chart). (Watch the related CreditMatters TV segment titled, “U.S. Municipal Housing Looks Forward To Another Strong Year,” dated Feb. 19, 2014.)

The U.S. federal government poses more headwinds for municipal housing issuers than do real estate markets although the thawing politics in Washington, D.C., appear to foster more stability than before. Tax reform, which gained some traction in early 2013, didn’t occur last year and may not progress in 2014. Budget cutbacks previously scheduled under sequestration could be reduced under the Ryan-Murray budget deal, which restores $65 billion in sequestration cuts over 2014 and 2015. Housing finance reform calls into question the federal government’s longstanding role in promoting housing affordability, but proposals for changing or eliminating Fannie Mae and Freddie Mac remain on hold. Despite a slightly more solid federal appropriation commitment to housing than under sequestration, municipal issuers with federal guarantees should fare better than those reliant on federal appropriations.

Finally, Standard & Poor’s will implement revised criteria for unenhanced multifamily projects, federally subsidized projects, privatized military housing projects, and bonds backed by multifamily loan pools. The proposed criteria would affect no more than 450 rated issues, covering 160 discrete projects or programs. We anticipate that once applied, the revised criteria could result in our raising 5% of the issue ratings and lowering 10%.

Standard & Poor’s baseline projection for the average unemployment rate is 6.9% in 2014 compared with 7.5% in 2013 and 8.1% in 2012. The increased income from employment translates to 2 million additional households, for a total of 123 million. Standard & Poor’s projects that the number of single-family housing starts will reach 810,000 in 2014 compared with 620,000 in 2013. Multifamily housing will likely grow at a similar pace, to 350,000 units in 2014 from 290,000 in 2013. We anticipate that these factors will reduce delinquencies in single-family loans and boost occupancy in multifamily properties.

The municipal housing industry has always led a dual existence with regard to interest rates: As capital market borrowers they want to issue bonds with the lowest yield, but as mortgage financiers they need a sufficiently high loan rate to support their bonds. Unlike other tax-exempt entities, housing finance agencies (HFAs) and issuers of municipal housing bonds compete with the private sector to serve individuals. In the case of HFAs, the customers are typically low- to moderate-income first-time homebuyers, for whom HFAs can provide affordable mortgage rates and down payment assistance.

The decline in mortgage rates has made the MRB model less viable. Bond rates can only go so low, so even though HFAs can issue debt at lower rates than they could 10 years ago, mortgage rates from lenders that are not tax-exempt are not much different from rates on loans financed through the municipal bond market. Thus, the difference between the rates on the bonds and the mortgages that would support them is often too thin to allow for a bond-financed loan.

HFA Performance Remains Strong Despite Challenges

HFA single-family indentures have retained high ratings in the aftermath of the housing downturn that accompanied the Great Recession. The main factors in the ratings — which are typically at least ‘AA’ — are the conservative profiles of the indentures, strong underwriting standards, traditional loan types, and substantial support from the U.S. federal government. (See “U.S. Public Finance Report Card: State Housing Finance Agencies’ Single-Family Programs Strengthen On Federal Support And Higher Equity,” published Dec. 19, 2013 on RatingsDirect.) Although rating changes have been rare, the indentures are building strength through higher equity and reserves, maintaining a manageable loan delinquency rate, and paying off some variable-rate debt.

Performance of single-family indentures has contributed to HFA issuer credit ratings (ICRs) that have never been higher as a group: A record 83% of HFAs have ICRs of ‘AA-‘ or better compared with 75% before the real estate downturn. Equity-to-asset ratios are, likewise, at an all-time high, nonperforming asset ratios are improving, and almost all HFAs have positive net income. (See “U.S. Public Finance Report Card: U.S. Housing Finance Agency Financial Ratios And Ratings Improve During A Weak Economy,” published Oct. 9, 2013.) Much of the improvement is the result of management reactions to real estate and financial market disruption.

Yet even in this area, activity by the federal government has had a dampening effect on HFAs. The federal response to the economic slowdown, namely the near-0% federal funds rate and quantitative easing, has resulted in lower investment returns and market mortgage rates too low to allow HFAs to operate within an MRB model (see chart). HFAs have shifted their origination platform to sales of U.S.-backed mortgage-backed securities (MBS) through the to-be-announced market. This maintains lending activity but without the loans and bonds associated with an MRB program. As a result, the balance sheets of HFAs shrink. As long as mortgage rates remain historically low, we anticipate that HFA balance sheets will continue to deteriorate.

The Federal Government Affects Ratings In Several Ways

The benefits of the federal government outweigh the negatives, even though the U.S. sovereign rating has been in play since 2011. The outlook on the rating no longer portends a negative rating action given that Standard & Poor’s revised the outlook to stable from negative on June 10, 2013. This affected 1,754 ratings that track the rating on the U.S. sovereign.

Sectors with strong federal support

Similarly, we anticipate that securitized multifamily housing will experience better outcomes, being that it benefits from stronger federal support. Debt issues with collateral in the form of MBS from Fannie Mae, Freddie Mac, and Ginnie Mae will match the rating on the U.S. sovereign, assuming no other elements of the transactions constrain the rating. Housing for the U.S. armed forces will maintain higher credit quality than much of the affordable multifamily market because of a consistent record of government appropriations to cover the collective housing costs of military personnel. The sector’s continuing strength largely reflects that the source of rental income is the Department of Defense’s basic allowance for housing (BAH), which has a strong record of congressional appropriation.

HUD support

The federal government’s commitment to other sectors is less certain. The U.S. Department of Housing and Urban Development (HUD) is the main source of public funding for affordable housing, and, as an entity of the federal government, is bound to congressional budget decisions; its funding declined by 12% in 2008 to 2012. More recently, sequestration resulted in cuts of more than $900 million to the $18.9 billion in Section 8 housing choice vouchers and $470 million to the $9.3 billion project-based Section 8 vouchers.. However, the 2014 omnibus bill based on the Ryan-Murray plan funds housing choice vouchers at $19.2 billion and project-based vouchers at $9.9 billion — both increased from the original fiscal 2013 appropriation.

Market Forces And New Criteria To Affect Unenhanced Multifamily Ratings

Sectors with less federal support will see more financial stress. Declining or stable asking rents, which are subject to income restrictions, offset some of the benefits that affordable multifamily properties have, such as declining vacancy rates, relatively stable operating costs, and locations in low-cost markets. Without explicit federal guarantees, the ratings on these properties are much more subject to market forces. Occupancy ranges from 80% to 97% for some of the stronger properties in high-demand markets. Occupancy for subsidized housing programs, such as Section 8, is very strong: Physical occupancy averages 98%, and 88% of these housing projects have occupancy of more than 95%. But balancing rental increases with operating expenses will be a challenge. The 2% decrease in average expenses in project-based Section 8 transactions in 2013 is a positive sign, but may not signal a trend.

The revised criteria that will go into effect this year apply to these security types. As mentioned above we anticipate taking no rating action on 85% of the issues, while perhaps raising ratings on 5% and lowering ratings on 10%.

Public Housing Experiencing Stress

Sequestration resulted in a 4.4% spending reduction in operating funds for public housing authorities (PHAs). In December 2013 we lowered the issuer credit rating to ‘A+’ from ‘AA-‘ on the Houston Housing Authority based on weaker financial performance related to lower federal funding. Also affected is capital fund financing program debt that PHAs issue and pay back with future grant appropriations. Because the stream of funding is not as certain as with BAH, we assume ongoing reductions in capital funding from the federal government, and to this point, reductions under sequestration have not been greater than what we anticipated.

Future Of GSEs Remains Unclear

Government-supported entity (GSE) reform poses a different risk to U.S. municipal issuers. The two main proposals for GSE reform (Corker-Warner in the U.S. Senate and PATH in the U.S. House of Representatives) increase down payment requirements to 5.0% compared with the 3.5% under many current affordable single-family loans that HFAs offer. Because many HFAs provide down payment assistance, the increased requirements could mean additional costs to the HFAs when they make up the difference. The additional costs could, in turn, decrease HFAs’ participation in the affordable housing market, thus limiting availability.

In 2012, affordable single- and multifamily housing loans accounted for $267 billion of the GSE loan production. Corker-Warner would assess a fee of five to 10 basis points on all loans to establish trust funds that would be available for housing and other purposes. Management estimates the fees generated for the trust funds at less than $1 billion annually. This figure is substantially lower than the current affordable housing support that the GSEs provide and could significantly reduce the activity of HFAs and other municipal issuers, in our view, cutting housing opportunities — both ownership and rental — for many working- and middle-class households. Although the level of commitment wouldn’t affect existing issues, a large reduction in the federal government’s affordable-housing footprint could have tremendous implications.

Conclusion

The municipal housing sector should continue its stable performance in 2014. As the year begins, we anticipate that a more predictable federal environment in terms of legislation and fiscal policy will provide a more solid foundation than in past years. In 2013, for instance, the federal government shut down for 16 days, Congress considered changing the municipal bond interest tax exemption and the mortgage interest tax deduction, and sequestration led to significant cuts to public housing funding. None of those variables is in play at this time. Reform of Fannie Mae and Freddie Mac remains a topic of discussion, but in even more muted tones than last year, as these entities are so profitable that they are on the verge of paying the U.S. Treasury more than the $187 billion they received from the federal bailout.

With a more settled federal situation, securities that rely on federal support should experience more stability. Indeed, the more than 1,700 issues with ratings matching the U.S. sovereign rating now have stable outlooks instead of the negative outlooks they carried from August 2011 to June 2013. We anticipate that issues without direct support of the U.S. government will continue to perform much as they have in the past. HFA ICRs should remain stable: In the past three months, we revised the outlooks to stable from negative on ICRs for California HFA and Utah Housing Corp. HFA single-family programs have more equity than ever as a whole, which should keep our ratings on them at least ‘AA’ in almost all cases. Bonds with less reliable and less predictable revenue streams will continue to experience more rating movement, especially those with limited or no federal support.

Download Table

2014-2015 Industry Economic Outlook for U.S. Public Finance Housing
	–Forecast/Scenarios–						–Actual–
	Downside		Baseline		Upside
	2014	2015	2014	2015	2014	2015	2013
Macroeconomic indicators
30-year fixed mortgage rate (%)	4.09	4.41	4.63	4.98	5.40	6.49	3.96
10-year Treasury note yield (%)	2.00	2.41	3.03	3.30	4.18	4.85	2.32
Unemployment rate (%)	7.59	7.68	6.47	5.82	6.05	5.00	7.45
Real GDP (% change)	0.58	1.84	2.77	3.25	4.13	4.01	1.68
Total nonfarm payrolls (% change)	0.75	0.78	1.76	2.03	2.46	2.58	1.64
Consumer Price Index (% change)	0.80	1.95	1.44	1.77	2.13	1.61	1.44
Households (mil.)	122.84	124.20	123.10	124.72	123.29	125.02	121.41
Median single-family existing-home price (000s $)	194.80	190.37	198.71	198.47	202.09	200.72	195.57
Median new-home sale prices (000s $)	261.67	254.38	265.77	266.02	263.72	252.29	264.53
Existing single-family home sales (mil. units)	4.42	4.70	4.70	5.12	5.22	5.28	4.52
Single-family housing starts (mil. units)	0.56	0.74	0.82	1.05	0.90	1.19	0.62
Multifamily housing starts (mil. units)	0.26	0.33	0.35	0.43	0.36	0.49	0.29
Federal government spending	(3.0)	0.1	(1.1)	0.0	(0.6)	0.9	(4.6)
Note: Standard & Poor’s U.S. Economic team’s forecasts are constructed using the Global Insight model of the U.S. economy. Forecasts are from “U.S. Economic Forecast: Two Economies Diverged in A Wood,” published Dec. 5, 2013 on RatingsDirect.

Primary Credit Analyst:	Lawrence R Witte, CFA, San Francisco (1) 415-371-5037; larry.witte@standardandpoors.com
Secondary Contact:	Mikiyon W Alexander, New York (1) 212-438-2083; mikiyon.alexander@standardandpoors.com