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The carry and financing trade in low WALA pools
admin | September 20, 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.
The prepayment differences lately between new MBS pools and the ones delivered to TBA is clear, especially for Ginnie Mae. Investors routinely pay up for the slower pace of new production and the better carry that comes with it. But the cost of financing matters. Investors that typically do not use dollar roll financing, including many banks, should be able to quickly recoup pay-ups for new Ginnie Mae pools through better carry. Investors that do use dollar rolls will have to wait longer. In conventionals, poor dollar roll financing in some coupons may make new pools more attractive than TBA.
Pools prepay very slowly for the first six months
Most investors expect that a newly originated loan will be unlikely to prepay, and fast speeds will hurt execution when an originator pools and sells loans into the secondary market. Therefore most lenders, as well as the FHA and VA, enforce policies designed to prevent rapid prepayments before a loan has seasoned at least six months.
However, it is impossible to prevent all refinancing with a conventional loan. A lender can prevent their own employees from refinancing a loan too early, but they can’t prevent the borrower from going to another lender. Third party origination channels—brokers and correspondent lenders—also have more freedom to contact a borrower to refinance and sell the loan to a different originator. But the FHA and VA always know the status of the loan being originated regardless of the lender handling the refinance, which leads to much slower prepayment speeds for low WALA Ginnie Mae pools (Exhibit 1).
Exhibit 1: <= 6 WALA loans have much flatter S-curves
Source: Fannie Mae, Freddie Mac, Ginnie Mae, eMBS, Amherst Pierpont Securities
The chart aggregates prepayment speeds from June 2018 through August 2019 for loans with less than twelve months of seasoning. Prior to June 2018 there were fewer restrictions on refinancing low WALA VA loans, and that is no longer representative of prepayment behavior today. Loans are grouped into conventional and Ginnie Mae buckets, and into seasoning buckets. The 0 to 6 WALA buckets are significantly slower than the 6 to 12 WALA buckets. The low WALA Ginnie loans are extremely slow, and the 6 to 12 WALA Ginnie loans are by far the fastest shown.
All low WALA pools carry well—ignoring dollar roll financing
All low WALA pools carry better than TBA if the investor ignores dollar roll financing, which may be reasonable if the investor cannot roll positions (Exhibit 1). Banks, for instance, typically cannot roll positions. Because of the huge prepayment speed differential, a low WALA Ginnie Mae pool carries especially well compared to TBA. Both the Ginnie Mae 30-year 3.0% and 3.5% pools have carry advantages roughly equal to the pay-up, meaning just one month of carry is enough to earn back the pay-up. Even the Ginnie Mae 4.0% pool only requires about two months to earn back the 16/32 pay-up. For conventional pools, the carry advantage offered by the spec pools is fairly modest. For example, even a low WALA conventional 30-year 4.0% is expected to prepay roughly 15 CPR at current interest rates, while the TBA is expected to prepay at 39 CPR. The carry advantage for that cohort is 3/32s, which is well below the market pay-up of 15.5/32s.
Exhibit 2: Low WALA Ginnie Mae pools carry much better than TBA
Note: Carry was calculated over a 6-month window assuming all positions finance at 6-month OIS + 25 bp. This assumes a zero WALA pool was purchased. The TBA is projected to prepay similarly to loans in the 6-to-12 WALA range. The carry advantage in the table represents average monthly carry of the 6-month window [carry advantage==(low WALA drop minus TBA drop)/6]. A positive carry advantage indicates that the spec pool carries better than the TBA.Source: Yield Book, Amherst Pierpont Securities
Dollar roll financing changes the equation
The availability of special financing in the roll market changes things. An investor in a spec pool forgoes the ability to finance through the roll market. If roll financing is better than pool financing, this reduces the benefit of paying a premium for the pool. TBA financing rates inferred from the current dollar roll market.
Exhibit 3: Special Ginnie Mae roll financing reduces the benefit of low WALA pools
Note: The 1-month financing rate is calculated for each TBA using the market drop and assumed prepayment speed. The spread to one month OIS is calculated and added to the 6 month OIS. This assumes the specialness of the current dollar roll persists for the next six months. Source: Yield Book, Amherst Pierpont Securities
The Ginnie Mae roll market currently offers special financing to all coupons, and this severely erodes the carry advantage of the low WALA spec pools (Exhibit 3). The 3.0% no longer earns enough carry over six months to cover the pay-up, and the 3.5% and 4.0% take much longer to earn back the pay-up.
Conventional dollar rolls, on the other hand, look extraordinarily expensive, with financing well above 1.95% for the 3.5% and 4.0% coupons. This makes the low WALA pool look more attractive since it takes less time for the spec pool investor to recoup the pay-up through better carry.
Calculating exposure to special dollar roll financing
It is also helpful to calculate the financing rate that leads to exactly no carry advantage (Exhibit 4). If dollar roll financing drops below this breakeven level, the carry on the TBA position will match the spec pool. As long as the financing rate remains above that level the specified pool should carry better than TBA.
Exhibit 4: Roll funding rates have to drop more to completely negate investing in low WALA
Source: Yield Book, Amherst Pierpont Securities
Financing rates on the Ginnie 30-year 3.5% and 4.0% would have to drop quite a bit more to fully erase the advantage offered by the spec pool; the much larger expected prepayment difference provides a larger buffer against special TBA financing. The conventional pools, however, lose any advantage at higher roll financing rates. For example, the 3.5% conventional TBA carries as well as the low WALA pool when financing drops to 1.53%, which is in the neighborhood of where the Ginnie rolls currently trade.
Conclusion
Low WALA pools can prepay substantially slower than TBA pools for about six months, and this difference is especially pronounced in Ginnie Mae pools. Current dollar roll financing offsets much of the carry benefit of low WALA Ginnie pools, while poor financing rates for conventional TBA boosts the value of clipping carry from a specified pool. For investors that cannot roll TBA positions, however, specified pools, especially Ginnie Mae, look likely to quickly recoup their cost.
Investors do need to be aware of the risks of this type of trade. Roll financing can change over the course of an investment horizon; the Ginnie Mae trade has a larger assumed speed differential so it is more resistant to changes in financing rates. The Ginnie trade may have more upside than the conventional trade, since the Ginnie rolls are trading special while the conventional rolls are very expensive right now.
The prepayment assumptions are another source of risk. If the low WALA pools prepay faster than expected, or the TBA prepays slower than expected, the trade will be hurt. Investors looking at low WALA Ginnie Mae pools should try to source pools with no VA loans, which tend to refinance much faster than FHA loans.
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