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Ginnie Mae speed fears weigh on price spreads

| February 21, 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.

Price spreads between Ginnie Mae II TBA and the UMBS TBA remain very low as investors continue to worry about rising prepayment speeds in Ginnie Mae MBS. The lower coupons—2.5%s, 3.0%s, and 3.5%s—show the biggest impact since they include a massive number of loans in-the-money to refinance and about to become eligible for FHA and VA streamline refinance programs. These coupons look undervalued compared to both the same-coupon UMBS pool and to the higher coupon Ginnie Mae MBS.

Priced low relative to conventional MBS

The three lower Ginnie Mae II coupons—2.5%, 3.0%, and 3.5%—are priced at, or very close to, the low points of the last year (Exhibit 1). Ginnie Mae pools in these coupons are more negatively convex than conventional pools, and investors have priced in expectations of faster speeds as interest rates have fallen. The MBA refinance index supports this observation. Last week the government index increased while the conventional index dropped. The largest speed increase should come in March (April report).

Exhibit 1: Lower coupon G2SF price spreads to UMBS remain near 1 year lows.

Data runs from February 20, 2019 through February 19, 2020. Price spread is G2SF minus FNCL. Source: Fannie Mae, Freddie Mac, eMBS, Amherst Pierpont Securities

The G2SF-to-FNCL price spread for the 3.0% coupon has fallen 27/32s since the beginning of the year and is currently 13/32s below the average value of the swap when the FNCL is priced near $102-00. Buying a 1 WALA Ginnie Mae 3.0% multi-issuer pool is one way to take advantage of this under performance, since FHA and VA loans provide very strong prepayment protection until they reach six or seven months of seasoning. This should provide prepayment protection as speeds increase over the coming months. The pay-up for the 3.0% multi-issuer pool is currently only 3.5/32s, and could be recovered quickly if the price spread returns to typical levels.

Investors that can buy custom pools have options to further enhance prepayment protection. One example would be to purchase a 3.0% 1 WALA 0% VA pool, since VA loans are far more negatively convex than FHA loans.

Lower coupon Ginnie Mae TBAs look the least expensive

Lower coupon Ginnie Mae II TBAs look inexpensive compared to UMBS TBAs, and also look inexpensive compared to higher coupon Ginnie Mae TBAs (Exhibit 2).

Exhibit 2: Ginnie Mae 3.0%s and 3.5%s appear to be the cheapest part of the stack

Data runs from February 20, 2019 through February 19, 2020. Price spread is between two G2SF TBA contracts. Source: Fannie Mae, Freddie Mac, eMBS, Amherst Pierpont Securities

The three higher coupon swaps—5.0%−4.5%, 4.5%−4.0%, and 4.0%−3.5%—all appear priced close to the high points of the last year. The 3.5%−3.0% swap looks fairly priced, while the 3.0%−2.5% swap is at the low end of the range. This suggests that 3.0%s and 3.5%s are both priced below typical levels, while the rest of the coupon stack looks rich.

Higher coupon Ginnie Mae pools have better convexity

Higher coupon Ginnie Mae TBA have better convexity than lower coupons, which is likely why the higher coupons look fairly priced compared to conventionals. Better convexity was evident in the January prepayment report, which was slower overall but had huge pickups in some Ginnie Mae cohorts. For example, Ginnie Mae 3.5%s issued in 2019 increased 56.7% overall in January, while the 4.5%s from 2019 slowed 4.9%.

Most loans in higher coupon Ginnie Mae pools have been refinanceable for a number of months. These loans have accumulated some burnout and are moving past the peak of the seasoning ramp. They are also deep in-the-money, so less sensitive to lower interest rates. All of that contributes to a better convexity profile. There are some low WALA loans in these coupons but they were originated with much higher spreads at origination (SATO), which is a measure of the credit risk of a borrower. Higher SATO indicates worse credit, since these borrowers were likely charged a higher rate to compensate the lender for the higher credit risk. High SATO loans typically have better convexity than low SATO loans, which also contributes to the better the convexity of higher coupon Ginnie TBAs.

All of the advantages in higher coupon TBA do not benefit lower coupons—there are many loans about to become eligible for streamlined refinancing and these loans were originated at low SATOs. The low seasoning means there isn’t any burnout. Therefore those TBA should exhibit much worse convexity than higher coupons.

But VA convexity should be worse in 2020

One word of caution is that the 2020 multi pools look likely to contain somewhat worse collateral than the 2019 pools. FHA and conventional loan limits increased in 2020, but VA loan limits went away completely at the start of the year. This was due to legislation passed by Congress last summer. This means that VA average loan sizes should increase more than FHA and conventional and that the Ginnie Mae multi pools remain exposed to the occasional extremely large VA loan. For example, a $3.3 million 100% LTV purchase loan is being placed in the February 2.5% 30-year multi pool (G2 MA6473) by Caliber.

VA loan deliveries into the multi pool are still subject to the 10% de minimis limit, so an increase in VA loan sizes must be offset by fewer loans being pooled. This should mitigate some, but not all, of the negative effect of removing VA loan limits.

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