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Pool WACs improve under UMBS

| June 21, 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. This material does not constitute research.

For months investors have been dealing with a growing cohort of MBS pools issued by the GSEs that include loans with much higher note rates than typical. High excess servicing valuations have encouraged originators to retain as much servicing as possible by selling loans into lower coupon pools. These pools have much worse convexity, which has driven down the value of TBA contracts. This practice has especially hurt 3.5%s. With the debut of UMBS, that has changed.

Steps taken by the GSEs and FHFA in June appear to be improving the quality of new production UMBS pools. The average spread between the note rate of the loans and the net coupon of the pool is lower than in prior months, and far fewer pools with very high spreads are being created. These pools should have better convexity and be more valuable. Eventually the TBA contract should also improve, but it could take some time.

New pooling restrictions began in June

As part of the UMBS initiative the FHFA and GSEs decided to limit the ability of an originator to deliver a loan into lower coupon pools. These changes are part of the overall effort to ensure the two GSEs’ pools prepay similarly.

The first restriction limits the spread between a loan’s note rate and the net rate of the pool to no more than 112.5 bp. This means any loan is eligible for delivery into only two coupons. The second restriction is that an originator cannot retain more than 50 bp of servicing. Any additional spread must be paid to the GSE as a guarantee fee. No matter which coupon the originator chooses, the GSEs buyup/buydown grid can be used to retain the maximum 50 bp of servicing. Therefore the originator no longer has an incentive to deliver into the lower coupon solely to retain more servicing.

Average spreads are coming down

Spreads rose steadily during the latter part of 2018, and especially near the end of the year and into 2019. Exhibit 1 shows the spread by coupon for Fannie Mae and Freddie Mac 30 year fixed rate pools, excluding specified pools. This pooling practice particularly hurt 3.5%s, and more recently (as rates fell) 3.0%s. These coupons would otherwise not have seen much production, so they were primarily filled with high rate loans. This drove up spreads considerably. For example, 3.0% spreads peaked at 110 bp in January.

Exhibit 1: Average spreads of new pools are tightening

Note: Average spread between gross WAC and coupon for GSE 30-year pools. Source: Fannie Mae, Freddie Mac, eMBS, Amherst Pierpont Securities

However spreads have started to recover. With the advent of the UMBS rules in June spreads on 3.5% pools have fallen nearly to the same levels seen in 4.0%s. 3.0% pools remain a little higher; this may reflect that the lowest coupon may be best execution for loans with higher guarantee fees. Delivering into a higher coupon would require cash upfront to buy down the guarantee fee, which may not be feasible.

The spread distribution of new pools has also improved

The average spread is only part of the story; the distribution of pools also matters. The TBA tracks the worst to deliver pools, not the average pool, so a tighter distribution of pool spreads should eventually help the TBA. Exhibit 2 is a histogram of the balance-weighted distribution of pools created for 3.0%s through 4.5%s. The x-axis represents the spread of each pool, bucketed into 5 bp intervals. The y-axis is the percent (by balance) of pools that fall in that bucket. For each coupon and time frame the bars add to 100%. The distributions are run before and after the UMBS pooling requirements were implemented.

Exhibit 2: Fewer pools were created with wide spreads

Note: Histogram of pool spread between WAC and coupon, by coupon and issuance time. Spread is calculated for each pool; distribution is balance weighted; bars within each subplot add to 100%. Source: Fannie Mae, Freddie Mac, eMBS, Amherst Pierpont Securities

The distribution changes dramatically in June for 3.0% and 3.5% pools. Prior to June roughly 79% of 3.0% coupon pools and 43% of 3.5% coupon pools had a spread greater than 100 bp. That has fallen to 5.7% of June 3.0% pools and 0.4% of June 3.5% pool (measured on 6/19/2019). However there are also fewer pools being created with lower WACs, so the distributions are significantly narrower. Even though the average spread for 4.0% and 4.5% pools hasn’t changed much, both coupons benefit from lower dispersion.

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