The wrap spread looks like 3 points until both notes are actually amortized

Question

Take a wrap where the headline spread is misleading. Underlying: 218k remaining at 3.9, roughly 22 years left, payment 1,430 plus escrow. Proposed wrap: 265k at 7.25 over 30 years, payment about 1,808. The wrap seller collects 1,808, pays out 1,430, keeps 378 a month. Fine. But the underlying amortizes on a 22 year schedule and the wrap runs 30, so the senior balance falls faster than the wrap balance. Around year eight or nine the seller's equity position in the paper is materially different from day one and the spread stops being the whole story. The open question is whether the faster senior payoff is a feature or a trap. It builds real value for the wrap seller, but it also means the monthly outflow is fixed and heavy relative to the inflow while the buyer's balance barely moves. If the buyer defaults in year four, the seller is foreclosing on a note where they have paid down someone else's lien with the buyer's money. How do people actually think about the term mismatch here, and does anyone match the wrap term to the remaining underlying term instead?

Rena Expert · Answer

The mismatch is doing you a favor on the balance sheet and hurting you on cash flow, and which one matters depends on whether you need the 378 or you're happy to accumulate equity.

Run it out. On your numbers the senior is retiring principal at roughly 720 a month early on and climbing steeply, because 22 years left at 3.9 is well into the amortization curve. The wrap at 7.25 over 30 is retiring maybe 205 a month at the start. So you're building around 515 a month of position in addition to the 378 of spread. That's the real yield, and it's why the headline 3.35 point spread understates the return while overstating the cash.

The default scenario you raise is the one to plan for, and your framing is right that you'd be foreclosing on a note whose collateral now carries a smaller senior lien than it did at origination. That's not a bad place to be, assuming the wrap is properly secured and recorded and your state's foreclosure process is one you can actually run at a cost you've priced. Judicial states will take longer and cost more, and that varies enough that you want a number from a local attorney before you sign, not after.

Matching the wrap term to the remaining 22 years is uncommon because it pushes the buyer's payment up hard, roughly 1,935 instead of 1,808 on 265k, and buyers doing a wrap are usually payment-sensitive. The more common answer is a 30 year amortization with a balloon somewhere in years five to seven, which caps your exposure to the underlying and forces the refinance conversation.

One thing your model is holding still that won't: the escrow on the senior loan. Tax reassessment after a sale can move that payment several hundred dollars, and it eats the 378 first.

laurenkim53 · Answer

The reassessment point is the one most likely to bite. In many counties a sale resets the assessed value to the purchase price, and the tax bill can jump 40 percent the following year. At 378 of monthly spread that is most of it gone, and the buyer's note is fixed.

The wrap spread looks like 3 points until both notes are actually amortized

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