Extension protection in low FICO pools
admin | October 12, 2018
This document is intended for institutional investors and is not subject to all of the independence and disclosure standards applicable to debt research reports prepared for retail investors.
For borrowers with poor credit scores, time tends to lead to faster rates of default, housing turnover or cash-out refinancing. The poor credit either leads to missteps, or the credit improves enough to give the borrower more flexibility. Either way, it’s potentially good news for investors buying related pools at a discount, especially in 30-year 4.0%s.
Initial call protection gives way to extension protection
Exhibit 1 (below) compares prepayment speeds for low and high FICO loans. The S-Curves are built using Fannie Mae and Freddie Mac’s loan level data. The population includes fixed 30-year loans originated in 2013 and newer with original LTVs between 70% and 80% and loan sizes between $200,000 and the base (not jumbo) conforming limit. Each S-Curve represents one year of seasoning.
Exhibit 1: Low FICO pools offer both extension and early call protection
Source: Fannie Mae, Freddie Mac, eMBS, 1010data, Amherst Pierpont Securities
In the first year low FICO loans clearly prepay slower when in-the-money. The GSEs charge a very high upfront loan-level price adjuster (“LLPA”) for low FICO loans. For example, a borrower with a 670 FICO score taking out an 80 LTV loan has to pay 2.75 points (in addition to any other LLPAs that apply). Using a 5x multiple implies a 55 basis point reduction in rate incentive. This elbow shift make the S-Curve look flatter.
However, in the second and third year low FICO loans have started to prepay faster in the out-of-the-money scenarios. After making one to two years of payments many borrowers’ credit scores will improve, boosting mobility and increasing the ability to do a cash out refinance. On the other hand, some borrowers will struggle and eventually default; Freddie Mac’s pool data indicates that buyout rates can reach 0.5 CPR to 1.0 CPR on low FICO pools. Both of these factors lift discount speeds.
In the fourth year the two S-Curves look very similar, although the low FICO loans continue to prepay a little faster out-of-the-money and now look slightly faster in-the-money as well. Some of the convergence is due to burnout in the higher FICO loans, which flattens their S-Curve.
Low FICO pool payups are a good value
Low FICO collateral tends to trade at very low payups, making it an inexpensive source of better convexity. Currently 4.0%s trade with almost no payup and 4.5%s with a roughly 3 tick payup. The theoretical value of the payup is estimated by dialing Yield Book’s new model (version 21.4) to replicate the historical S-Curves on low FICO collateral—slower refinances initially, faster out-of-the-money speeds with a flatter S-Curve in years 2 and 3, and finally a slightly faster S-Curve with a similar shape in years 4 and beyond.
Exhibit 2: Low payups for low FICO pools look cheap (as of 10/10/2018)
Source: Yield Book, Amherst Pierpont Securities
The 4.5%s are trading at roughly 40% of theoretical value, suggesting they are inexpensive. The 4.0%s are even more interesting, since the theoretical payup is higher than on 4.5%s. This suggests that much of the value from these pools comes from the extension protection. Meanwhile the market payup is actually lower on 4.0%s, making them an especially good value if rates continue to move higher.
This material is intended only for institutional investors and does not carry all of the independence and disclosure standards of retail debt research reports. In the preparation of this material, the author may have consulted or otherwise discussed the matters referenced herein with one or more of SCM’s trading desks, any of which may have accumulated or otherwise taken a position, long or short, in any of the financial instruments discussed in or related to this material. Further, SCM may act as a market maker or principal dealer and may have proprietary interests that differ or conflict with the recipient hereof, in connection with any financial instrument discussed in or related to this material.
This message, including any attachments or links contained herein, is subject to important disclaimers, conditions, and disclosures regarding Electronic Communications, which you can find at https://portfolio-strategy.apsec.com/sancap-disclaimers-and-disclosures.
Copyright © 2023 Santander US Capital Markets LLC and its affiliates (“SCM”). All rights reserved. SCM is a member of FINRA and SIPC. This material is intended for limited distribution to institutions only and is not publicly available. Any unauthorized use or disclosure is prohibited.
In making this material available, SCM (i) is not providing any advice to the recipient, including, without limitation, any advice as to investment, legal, accounting, tax and financial matters, (ii) is not acting as an advisor or fiduciary in respect of the recipient, (iii) is not making any predictions or projections and (iv) intends that any recipient to which SCM has provided this material is an “institutional investor” (as defined under applicable law and regulation, including FINRA Rule 4512 and that this material will not be disseminated, in whole or part, to any third party by the recipient.
The author of this material is an economist, desk strategist or trader. In the preparation of this material, the author may have consulted or otherwise discussed the matters referenced herein with one or more of SCM’s trading desks, any of which may have accumulated or otherwise taken a position, long or short, in any of the financial instruments discussed in or related to this material. Further, SCM or any of its affiliates may act as a market maker or principal dealer and may have proprietary interests that differ or conflict with the recipient hereof, in connection with any financial instrument discussed in or related to this material.
This material (i) has been prepared for information purposes only and does not constitute a solicitation or an offer to buy or sell any securities, related investments or other financial instruments, (ii) is neither research, a “research report” as commonly understood under the securities laws and regulations promulgated thereunder nor the product of a research department, (iii) or parts thereof may have been obtained from various sources, the reliability of which has not been verified and cannot be guaranteed by SCM, (iv) should not be reproduced or disclosed to any other person, without SCM’s prior consent and (v) is not intended for distribution in any jurisdiction in which its distribution would be prohibited.
In connection with this material, SCM (i) makes no representation or warranties as to the appropriateness or reliance for use in any transaction or as to the permissibility or legality of any financial instrument in any jurisdiction, (ii) believes the information in this material to be reliable, has not independently verified such information and makes no representation, express or implied, with regard to the accuracy or completeness of such information, (iii) accepts no responsibility or liability as to any reliance placed, or investment decision made, on the basis of such information by the recipient and (iv) does not undertake, and disclaims any duty to undertake, to update or to revise the information contained in this material.
Unless otherwise stated, the views, opinions, forecasts, valuations, or estimates contained in this material are those solely of the author, as of the date of publication of this material, and are subject to change without notice. The recipient of this material should make an independent evaluation of this information and make such other investigations as the recipient considers necessary (including obtaining independent financial advice), before transacting in any financial market or instrument discussed in or related to this material.