MBS: High pay-ups for specified pools shouldn’t last forever
admin | April 12, 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.
The price premium of specified pools over TBA has moved up dramatically over the last few months, but the move may not last forever. Some of the move is due to lower interest rates, but the high gross weighted average coupons and negative convexity of pools issued since December has also played a role. Specified pools arguably look better because TBA looks worse. But once UMBS launches in June, the trend should start to reverse.
Spreads should decline when UMBS goes live
The UMBS initiative includes two provisions that should control the spread between gross WAC and net coupon—the first directly caps the spread at 112.5 bp and the second caps the servicing strip at 50 bp. A simple example shows how capping servicing reduces, or removes, an originators incentive to pool int o lower coupons.
Consider a loan with a 4.50% note rate and a 25 bp guarantee fee. The originator has three delivery options:
- Sell into a 4.0% coupon pool and retain 25 bp servicing.
- Sell into a 3.5% coupon pool, retain 50 bp servicing, and buy up the guarantee fee to 50 bp.
- Sell into a 4.0% coupon pool, retain 50 bp servicing, and buy down the guarantee fee to 0 bp.
In a buy-up the originator receives cash from the GSE and pays a higher running guarantee fee; in a buy-down the originator pays cash up front and pays a lower running guarantee fee.
The originator can retain 50 bp delivering into either coupon so there is no incentive to deliver into the lower coupon purely to retain more servicing. Under the UMBS pooling parameters, the originator is no longer permitted to sell the loan into a 3.0% pool or retain 75 bp while selling into a 3.5% pool.
Pay-ups should eventually fall too
The most egregious pooling came in 30-year 3.5% pools, with nearly every pool issued from December through March coming with spread of over 90 bp; the average spread peaked at 118 bp in January. This is roughly $15 billion produced and 3.7% of the available float in that coupon. Only about 33% of 30-year 4.0% pools had a spread higher than 90 bp, and the average spread peaked at roughly 90 bp. But that was roughly $23 billion of pools issued and 5.8% of the float.
The UMBS changes will cap the production of pools similar to the high WAC pools of December through March, so this cohort of pools will begin to shrink, especially since they should prepay a bit faster than other pools of the same coupon. Eventually, through pay-downs and burnout and WAC drift, these pools should shrink in size and prepay better. This should improve the value of TBA.
It is important for investors to understand that as the TBA improves, today’s premium pay-ups for specified pools should fall. Exhibit 1 (below) estimates how much pay-ups will decline as the WAC of the TBA deliverable improves.
Exhibit 1: Payups will decline as the TBA deliverable improves
Source: Yield Book, Amherst Pierpont Securities
Payups were estimated by running 3.5% and 4.0% January Fannie major pools on March 27, the recent low in rates. The January pools had very high gross WACs. The prepayment model’s elbow was then dialed to simulate the effect of a falling gross WAC; valuations were run at constant OAS to the TBA.
A minimal estimate is that the UMBS rules will lower gross WACs on 3.5% pools by around 10 bp and on 4.0% pools by roughly 5 bp. The table shows that those moves would improve payups by roughly a couple of 32s on both coupons. However, this estimate assumes that originators would still attempt to create the widest spread pools possible under the new rules, even though the incentive to do so goes away with UMBS. Therefore it is also possible that gross WACs could revert to something much lower. For example, a typical historical spread has been roughly 80 bp. At that level payups on 3.5%s would fall by 12/32s and on 4.0%s by 6/32s.
Even though the quality of new pools could improve very quickly, it will take time for the TBA deliverable to improve. But over time there should be downward pressure on pay-ups, especially on the 30-year 3.5%, which has been the most abused coupon.
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