An improving bid for GSE loans from private MBS
admin | May 10, 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 revival of the private MBS market has come in part from the flow of agency-eligible loans into private execution. As much as 12% of February’s Fannie Mae and Freddie Mac production, highly concentrated in investor and jumbo conforming loans, would have commanded a higher price in private MBS. If ‘AAA’ private MBS spreads continue to ratchet tighter, the flow of agency-eligible loans into private securities should increase substantially.
The bid improves as ‘AAA’ private MBS tighten
The flow of agency-eligible loans into private MBS is not new. The first private deal fully backed by agency-eligible loans priced in April 2018, and a handful of deals fully backed by agency-eligible investor loans has priced since. Roughly half the collateral backing prime MBS deals since early 2018 would have been agency-eligible based on loan amount and geography. (Exhibit 1)
Exhibit 1: The population of conforming-balance loans in recent private deals
The recent rally in prime ‘AAA’ spreads will likely only push more agency-eligible loans into private execution. Spreads on super senior ‘AAA’ pass-throughs started the year $2-00 back of their 30-year TBA benchmark but recently have tightened to roughly $1-00 back of TBA. Front sequential spreads that started the year $2-00 back of their 15-year TBA benchmark have rallied to roughly $1-08 back. Last cash flow sequential spreads have lagged the tightening in shorter duration bonds, but recent new issue guidance suggests they may tighten as much as 10 bp from recent levels of roughly 140 bp over interpolated swaps. The tightening in last cash flows could add as much as $0-10 to $0-12 of structural arbitrage, assuming a 75/25 front/back sequential split, putting sequential execution inside of $1-00 behind the TBA benchmark.
Estimating the percentage of GSE loans with a better potential private takeout requires a series of assumptions, the most critical one being the spread at which the senior pass-through trades behind its TBA benchmark. The flow of GSE loans into private MBS will ultimately be highly levered to this spread. Assuming a senior pass-through pricing $1-00 back would push 12% of loans sold to the GSEs in February into private MBS. Widening that spread to $1-16 back of TBA would reduce the flow of GSE loans into PLS to 8%. Different types of loans will be more levered to changes in the price of the ‘AAA’ pass-through than others. Loans with more margin in private execution, like investor loans, are less levered to changes in pass-through spreads while loans with thinner margins are more so.
Our universe includes all loans pooled by the GSEs with an April 2019 first payment date, effectively capturing February’s production and totaling just over $39 billion of principal. The share that might go to private execution varies across investor loans, conforming jumbo, cash out refinances, and high FICO loans. This taxonomy is not mutually exclusive and follows a waterfall by story, meaning that a jumbo conforming bucket will have both investor loans and cash out refinances. But high FICO loans that are further down the waterfall will exclude all other story collateral. Potential private story collateral comprised 45% of GSE production in February. (Exhibit 2)
Exhibit 2: The population of PLS story collateral in GSE production
Each loan is stripped to its closest pass-through rate, a capital structure is applied based on rating agency guidance, and the subordinate stack is priced. Any excess coupon is priced at a multiple implied by the applicable Fannie Mae 30-year coupon swap. The ‘one-time’ ‘AAA’ pass-through—meaning the bond is not a super-senior—is then priced first at $1-00 and then at $1-16 back of the loan’s appropriate TBA benchmark after being stripped down, and a price for the loan is derived based the two ‘AAA’ pass-through spreads. The loan is also priced using applicable GSE guarantee fees, Loan Level Pricing Adjustments (LLPAs) and market-based, specified pool pay-ups to derive a price for agency delivery.
The private MBS price is then compared to the agency delivery price to derive best execution. The amount of loans that flow to PLS execution will vary based on ‘AAA’ pricing with some stories more sensitive to changes in that spread than others. Intuitively, loans with a greater margin between PLS and agency execution will largely still flow to PLS despite wider ‘AAA’ spreads, loans with thinner margins will see increasing amounts of fallout as ‘AAA’ spreads widen. 65% of agency investor loans originated in February would flow to PLS assuming ‘AAA’ pricing $1-00 back of TBA with an average price advantage of $1-04 over agency execution. Given the relatively large advantage, widening the ‘AAA’ spread to $1-16 would only reduce the flow of investor loans by 6% to 59% of February’s production. At $1-16 back of TBA, the price advantage in PLS execution would still be $0-27 on investor loans flowing into PLS.
By comparison, conforming jumbo loans would see a significant decline in the population of loans flowing into PLS assuming wider ‘AAA’ spreads. At a spread of $1-00, 55% of conforming jumbo loans originated in February would have more favorable PLS execution, widening the spread to $1-16 would reduce the share of February’s conforming jumbo to PLS to 24%. This appears to be primarily driven by both the initially thinner margin on PLS execution and the significant compression of that margin assuming wider ‘AAA’ spreads. At $1-00 back of TBA the average PLS price advantage over agency execution is just over $0-16, with spreads wider that price advantage falls to just over $0-08.
Exhibit 3: Some stories more levered to AAA spreads than others
While some stories are more levered to wider spreads, we would expect ‘AAA’ spreads to remain tight and potentially rally in some parts of the cash flow structure. A downturn in supply should keep pass-through spreads anchored in the context of $1-00 back of TBA. Front sequential spreads will likely remain well bid in the context of $1-08 to $1-12 back of their 15-year TBA benchmark as a result of strong money manager demand for out-of-index 15-year surrogates. Last cash flow spreads have lagged the tightening and look to be the most inexpensive part of the structure both within private MBS and relative to comparable agency cash flows. As such, they look like they may tighten somewhat significantly. Any material spread tightening will only improve PLS execution, likely pushing more agency eligible loans into private label trusts.
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