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Gross coupons and other prepayment effects of the new UMBS rules

| March 1, 2019

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.

One requirement for a successful transition to a new Single Security MBS market is alignment in prepayment speeds across the two GSEs. Fannie Mae and Freddie Mac’s regulator published final  rules on February 28 designed to do that. Key items in the new rules: limits to MBS gross coupons, new monitoring of worst-to-deliver pools and a sandbox for experimenting with new loan programs.

The FHFA reigns in gross coupons

The GSEs have long offered lenders significant flexibility to deliver loans into a variety of coupons. Fannie Mae permits the spread between the loan’s interest rate and the pool’s coupon to be as high as 250 bp; Freddie Mac limits this to 200 bp in single issuer pools and 125 bp in their MultiLender Swap pools (the equivalent of Fannie Mae Major pools). This practice allows the creation of low coupon pools that prepay like higher coupon pools, which is a concern for investors and could be a source of prepayment discrepancies between the GSEs.

To address this issue the Federal Housing Finance Agency will impose a maximum spread of 112.5 bp beginning later in 2019. This still permits any loan to be delivered into a choice of two coupons. But the GSEs have a legitimate reason to offer some flexibility and a higher maximum spread to lenders—the running guarantee fee is on average 41 bp, according to the FHFA, and the GSEs charge certain loans very high initial loan level price adjusters, or LLPAs.

For example, an investor loan could have an LLPA of 412.5 bp, which (using a 5× IO multiple) is equivalent to 82.5 bp running guarantee fee. A 5.125% loan paying that LLPA would be very difficult to deliver into a 4.5% pool, and would still require a guarantee fee buydown to deliver into the 4.0% pool.

The FHFA will also require that lenders cannot retain more than 50 bp of servicing. This means that loans delivered into the lower coupon are more likely to a result of high guarantee fees and less by lender discretion to retain excess servicing. This should reduce the adverse effects of including higher note rate loans in lower coupon pools, since these loans would likely have to pay the same high guarantee fee if they refinance.

Prepayment speed alignment of worst-to-deliver pools

In order to assess speed alignment, the FHFA will monitor prepayments on the worst quartile of pools within each eligible cohort in addition to overall cohort prepayments. A cohort is a group of TBA-eligible pools with the same coupon, origination year, and maturity. A cohort must have greater than $10 billion unpaid principal balance to be monitored.

The worst quartile pools are determined after excluding specified pools, while overall cohort speeds include specified pools. The FHFA is currently using these specified pool types:

  • Maximum loan balance less than $200,000.
  • Minimum LTV greater than 80%.
  • Maximum FICO score less than or equal to 700.
  • 100% investor properties.
  • 100% loans from New York, Texas, and Puerto Rico.

Prepayment speeds will be compared using 3-month CPR. A misalignment is 5 CPR on the worst quartile or 2 CPR on the cohort, while a material misalignment is 8 CPR on the worst quartile or 3 CPR on the cohort. The FHFA will conduct stronger investigations into material differences.

Small programs can be exempted from these rules

The FHFA has defined a de minimis exception for small programs offered by the GSEs that are expected to prepay materially differently. Such a program cannot exceed $5 billion of unpaid principal across the entirety of one GSEs TBA-eligible pools. While the exception doesn’t prohibit creating pools concentrated in these programs, limiting the overall program size and the ongoing prepayment speed monitoring likely limit the risk of being delivered an atypically fast pool. The rule is intended to permit the GSEs to deliver innovative products that benefit borrowers.

Conclusion

The FHFA’s final rule addresses some of the concerns raised by stakeholders since the initial proposal last September. Unfortunately there was little done to assure investors that the FHFA would take certain action to correct prepayment misalignments that may arise. However, constraining lenders’ ability to deliver loans into a variety of coupons and retain a lot of servicing is a welcome change and should benefit the TBA market.

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