Prepayment protection in 0% VA pools
admin | August 9, 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.
Despite successful efforts by Congress and Ginnie Mae to discourage some originators’ aggressive efforts to refinance loans insured by the US Department of Veterans Affairs, VA loans continue to refinance at a much faster pace than FHA loans. Investors can capture this difference by creating pools entirely of FHA and other Ginnie Mae-eligible loans, which should prepay more slowly than VA if interest rates fall. These pools should be worth a substantial premium to new Ginnie Mae multi-lender pools. And with the MBA refinancing indices showing government refinancing rising much faster than conventional, 0% VA pools should be valuable.
VA borrowers prepay quickly when rates drop
Congress and Ginnie Mae have taken a number of steps to control VA prepayment speeds, generally focusing on refinancings for reasons other than a decline in interest rates. Some lenders, for example, would originate a loan at an above-market rate and immediately refinance it. Investors that bought a pool containing these loans would quickly lose any price premium to par. In some instances, the borrower might not get any material benefit from refinancing or even lose money.
Some of the efforts to control prepayments include prohibiting refinances until loan has seasoned a certain number of months—this ends up being roughly seven months from closing—and requiring refinances to pass net tangible benefit tests. The effort has also excluded specific lenders from participating in Ginnie Mae’s multi-lender pooling program.
Policymakers do not want to prevent VA borrowers from refinancing when interest rates decline, however. The VA borrower tends to be higher credit quality and more sophisticated in managing their finances than the typical FHA borrower. They are similar to a conventional borrower, but with access to a low cost, streamlined refinance program.
Many VA-eligible borrowers choose a VA loan because it is less costly than a conventional loan, even when the borrower puts 20% down on the latter. For example, Wells Fargo’s website recently has quoted 3.875% for a 30-year conventional loan and 3.25% for a 30-year VA loan, and the VA borrower does not need to pay an annual insurance premium.
An FHA borrower, in contrast, generally has no alternative sources of financing for their home. A conventional loan is generally cheaper than an FHA loan if the borrower can afford to make a slightly larger down payment. This implies that most FHA borrowers are unable to make any more than the down payment required by the FHA.
Historical FHA and VA prepayment speeds for two cohorts of 4.0% coupon Ginnie Mae pools illustrate that the VA borrowers prepay faster (Exhibit 1). The first cohort includes loans originated in Q4 2016, which predates the interest rate drop in 2017. The second cohort was originated in Q3 2018, which is after the legislation Congress passed in May 2018 that placed limitations on VA refinances.
Exhibit 1: VA loans prepay faster than FHA loans
The 2016-vintage VA loans prepaid nearly 20 CPR just a few months into 2017, while the FHA loans were still prepaying close to 0 CPR due to low-WALA refinance restrictions in the FHA program. The VA loans spiked to 80 CPR when interest rates dropped in mid-2017 while the FHA loans only reached 40 CPR. The 2018 vintage VA loans initially prepay as slowly as the FHA loans, since the VA program now prohibits low-WALA loans from refinancing. There is a slight difference in timing between the two programs—the FHA loans can prepay after making six payments while the VA legislation requires a 7-month wait. This difference is visible in the chart, as the 2018 FHA loans start to ramp earlier than the VA loans. Yet once the VA borrowers are able to refinance, they quickly begin to prepay much faster than the FHA loans.
Ginnie Mae multi-lender pools contain many VA loans
Loans that prepay quickly in response to lower interest rates aren’t necessarily a problem. For example investors are willing to buy negatively convex pools of high balance loans issued by Fannie Mae, Freddie Mac, and Ginnie Mae. But these jumbo loans cannot make up more than 10% of the total balance of a TBA-deliverable pool, known as the de minimis limit. However, VA loans accounted for 46% of the balance of 30-year fixed rate multi lender pools issued in 2019.
A pool that contains 0% VA loans should have a better prepayment profile than a typical multi-lender pool. Exhibit 2 shows S-curves for VA loans and FHA loans, the latter constrained to have original loans sizes greater than $200,000. All the loans are between six and 60 months seasoned, and performance is from June 2018 through June 2019, reflecting any improvements to VA speeds from efforts by Congress and Ginnie Mae.
Exhibit 2: 100% FHA loans prepay slower than the multi pool
Two other S-curves are included. One represents prepayments typical of multi- lender pools—a blend of FHA and VA speeds. The multi-lender pools even include some loans with balances less than $200,000 yet still have a steeper S-curve than the FHA loans. The final S-curve flattens the refinance portion of the multi lender S-curve by roughly 15% to match the FHA-only speeds.
This comparison assumes that a 0% VA pool would only contain FHA loans. However any Rural Housing Service or Public Indian Housing loans included would further improve the convexity of the pool. These loans have very flat S-curves.
The FHA loans should command a significant pay-up over the multi lender pool
The theoretical pay-up for these loans can be calculated by running the July multi lender pools through Yield Book (Exhibit 3). The pools are run through Yield Book at the TBA OAS tob calculate prices, once using the base Yield Book prepayment model and once using a version of the model dialed to have a 15% flatter S-curve. The difference in the two prices is the theoretical payup for the pool of new FHA loans over a new multi lender pool. Since the multi lender pool trades at a payup to the TBA the payup over TBA for the 0% VA pool will be higher by that same amount.
Exhibit 3: Theoretical payups of 0% VA pools over low wala
Payups for this collateral range from $0-16+ for a 3.0% coupon pool to $0-27 for a 4.0% coupon pool. A standard benchmark is to consider a payup less than or equal to 40% of theoretical value to be inexpensive, which implies investors should be willing to pay up to $0-06+ for a 3.0% coupon pool and $0-11 for a 4.0% coupon pool. Since there isn’t a well-established market for this type of collateral, sourcing these loans at those levels is likely possible.
Interest rates have fallen substantially over the last few months and mortgage prepayment speeds are rising in response. Investors can benefit from finding previously unrecognized sources of prepayment protection, since payups increase for prepay protected collateral when interest rates fall. The disparity between FHA and VA prepayments and the abundance of VA loans in the multi lender pools imply that 100% FHA pools should offer significant value over the multi lender pools.