Call activity escalates in legacy PLS
admin | January 17, 2020
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 legacy private label universe becomes increasingly callable as it pays down and more deals’ balances fall below the threshold to execute a clean-up call. A fairly seismic shift occurred late last year when banks, led by Wells Fargo, began calling legacy trusts en masse, reducing the outstanding legacy universe by $15 billion. This call activity is likely to remain elevated and expand to non-bank shelves, though the motivations to call a deal differ depending on who holds the rights. A profile of the outstanding universe helps assess which shelves have a greater likelihood of being called across both bank and non-bank trusts.
The right and motivation to call varies by holder
Holders of the rights to collapse outstanding trusts and take back the underlying loans vary – with banks, REITs, mortgage servicers and specialty finance companies all having some ability to call outstanding deals – though these holders differ in their motivations. Banks that own servicing and call rights on their legacy shelves are only likely to execute the par call when it’s economically feasible. First, from a regulatory capital perspective, banks would likely not be able to hold mezzanine or subordinate bonds that trade below par which would allow them to call deals where the underlying loans trade at a discount. Additionally, banks would not likely call deals with large amounts of non-performing loans which would drive the collateral price below par as they require additional risk-based capital.
Conversely, non-bank holders of call rights have significantly more latitude to own securities that would make collateral calls where the loans trade below par economically efficient and hold non-performing loans. A side by side analysis of Countrywide’s CWL shelf illustrates this disparity in call incentive. Deals called by mortgage REIT New Residential (NWZ) and subsequently re-securitized had a much lower percentage of always performing loans (APL), a 1.75 bp lower average gross WAC (GWAC), and an average price below par – fully 6.5 points lower than other parties who executed calls on CWL deals last year (Exhibit 1).
Exhibit 1: Comparing collateral calls across the CWL shelf in 2019
Legacy bank issued deals called last year where the collateral was not re-securitized had high percentages of APL, low percentages of NPL, and average prices above par (Exhibit 2). Until recently, clean up calls on legacy bank shelves have been limited to loans backing BOAMS and BOAA trusts that were ultimately re-securitized by third parties. However, calls executed by Wells Fargo in the fourth quarter of last year may signal an increased appetite by banks to portfolio loans that can be called at par when the WACs are far greater than coupons of new loans being originated for portfolio retention. This increased appetite is likely fueled a need to add high yielding assets to offset deposit growth and protect net interest margin given the current low interest rate environment. Absent a material sell off in rates and steepening of the yield curve, banks could continue to actively collapse legacy trusts stocked with high WAC loans with strong performance histories.
Exhibit 2: Wells Fargo led calls of bank issued legacy trusts last year
Call risk on bank versus non-bank shelves
Calls on legacy bank shelves appear poised to remain elevated this year due to the substantial outstanding volumes coupled with meaningful premiums on a few large bank shelves. While the average price of collateral backing WFMBS trusts is below par, estimates are that roughly half of the remaining deals are still trading above par, and the collateral price is below $99 on just three outstanding deals. Call activity on that shelf is expected to continue on deals trading above par. Average prices on loans backing Wells Fargo’s legacy WFALT Alt-A shelf are trading north of a three point premium over par, but the calls are likely to be localized to prime collateral despite the significant premium. Across legacy Bank of America trusts, loans backing the BAFC and BOAA shelves are trading at north of a point premium to par and appear to be likely call candidates this year with loans backing BOAMS trusts trading at a slight premium where more seasoned 2002 to 2004 trusts appear more likely call candidates (Exhibit 3).
Exhibit 3: Estimating call candidates across legacy bank shelves
Call activity across non-bank shelves is also expected to remain elevated due to favorable fundamentals. Non-performing loan buckets should continue to shrink along with the frequency of loan modifications, pushing prices on collateral pools higher. Home price appreciation and amortization should exert downward pressure on LTVs of legacy pools, creating another potential tail wind to loan prices. The combined effect should expand the potential universe of callable trusts to include a growing population of legacy Alt-A and hybrid ARM loans.
The impact on investors to a trust being collapsed depends on their bonds’ position in the capital structure: mezzanine or subordinate bonds that trade at a discount have potentially significant upside optionality to call, while premium senior bonds may have significant downside risk.