Bad credit news may be good news for MTA IO

| July 10, 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. This material does not constitute research.

One asset that could offset some of the credit risk from the ongoing Covid crisis is interest-only classes of legacy pay-option ARM MBS. The sector should benefit from depressed prepayment speeds driven by elevated levels of borrower forbearance. And while all IO would benefit from slower speeds, certain types of basis IO also benefit from Fed easing and potentially the transition from LIBOR to SOFR at the end of next year.

A refresher on MTA basis IO

MTA basis IOs are bonds structured off of option ARM deals issued before the 2008 financial crisis. The interest rate on loans behind these deals floats with 12-month MTA, or monthly Treasury average, while the interest rate on the MBS float with 1-month LIBOR, hence the basis IO. MTA is calculated as the 12-month moving average of 1-year constant maturity Treasury rates, so MTA and LIBOR can differ substantially. While structures will vary deal to deal, these bonds usually benefit from an increase in the spread between a high value of 12-month MTA and a lower value of 1-month LIBOR.

These bonds have become increasingly attractive given the recent decline in 1-month LIBOR. Over the past 2.5 years, the average difference between 12-month MTA and 1-month LIBOR has been just 12 bp. That spread has gapped out to more than 100 bp as of June. Admittedly, forward MTA rates predict that this gap will narrow significantly over the next year. But given the lagging nature of the index, investors still can still benefit from greater carry associated with the difference between the two indices in the near term. (Exhibit 1)

One example of an MTA basis IO is CWALT 2006-OA21 X. The X class is stripped off of the entire collateral balance. The bond’s coupon is derived from the difference between the collateral net WAC and coupons of the senior and subordinate bonds. The IO gets paid at the top of the interest payment waterfall, where, absent the need to repay interest shortfalls, its coupon will be paid pro-rata with the senior certificates. The senior and subordinate bonds in the deal are structured as 1-month LIBOR floaters. Therefore, as LIBOR decreases and MTA lags, the basis IO coupon will increase.

Exhibit 1: MTA IO benefits from wide spread between MTA and LIBOR

Source: Intex, Bloomberg LP, Amherst Pierpont

Why Option ARM IO may outperform

Option ARM IO may outperform other non-agency derivatives due to a few other factors. First, outside of legacy subprime, where it is difficult to find pure IO exposure, option ARM collateral has the highest absolute amount of loans either delinquent or modified and in forbearance than any other sector of the legacy market including recently securitized legacy loans. Elevated forbearance and delinquency rates should suppress prepayments on option ARM loans, enhancing carry on IOs backed by the collateral (Exhibit 2).

Exhibit 2: Option ARMs have higher delinquencies than most other cohorts

Source: Amherst Insight Labs, Amherst Pierpont

Additionally, option ARM collateral by and large has outsized exposure to judicial foreclosure states like New York, New Jersey and Florida relative to other cohorts. Given the long liquidation lags that already exist in judicial foreclosure states, specifically New York and New Jersey, which will likely only further extend due to Covid-19 related foreclosure moratoriums and court closures, it seems unlikely that these delinquencies will materialize into losses that would cause write-downs and curtail the IO any time in the near future.

In fact, given the amount of built-up borrower equity in the cohort, it seems that there is a greater likelihood of modification than foreclosure and subsequent liquidation on loans that roll into late stage delinquencies. If a greater amount of previously always-performing option ARM loans become modified, historical prepayment rates suggest speeds should slow down materially. Trailing prepayment rates show that always-performing loans have prepaid almost 20 CRR faster than modified re-performing ones, which have paid roughly in-line with non-performing loans where the prepayment was likely the function of liquidation with no loss severity (Exhibit 3). Admittedly, a high concentration of RPLs may mean the coupons on modified loans may be fixed for some period and capped at a certain rate, potentially mitigating the effect of the MTA-LIBOR basis.

Exhibit 3: Option ARM RPLs prepay much slower than always performing loans

Source: Amherst Insight Labs, Amherst Pierpont

Application for MBS portfolios

MTA basis IO may be an attractive addition to MBS portfolios for a couple of reasons. In addition to offering attractive yield and carry, unlike traditional IO, MTA basis IO trades with positive duration, similar to agency inverse IO, because even though the cash flow is getting shorter due to rising prepayments, the bond’s coupon is increasing. Given the drop in rates and overall duration shortening of MBS portfolios associated with the rally, it likely makes sense to add IO with positive duration rather than further exacerbate duration shortening by adding IO that trades with negative duration. The key difference between MTA IO and most agency inverse IO is that the loans backing these bonds are burned out and often credit impaired. As a result the prepayment risk and subsequent cash flow contraction is mitigated to some extent, increasing the benefit of the larger coupon as interest rates fall. Additionally, while the coupon is capped on agency inverse IO as a function of the strike and the level of 1-month LIBOR, MTA basis IO is not capped. And while challenging given the incongruity of index replacement language across the legacy market, MTA IO may have significant potential upside to LIBOR going away at the end of 2021 as language in certain trusts would effectively fix coupons on liabilities pegged to LIBOR at its last observed value.

With that said, MTA IO is not without its own unique underlying risks. As stated earlier, large scale modifications would potentially mitigate the benefit of the MTA LIBOR basis if the underlying loans’ coupons were converted to fixed rates. And while prepayment risk in these bonds may be mitigated by the underlying collateral, call risk may not be and remains one of the biggest risks associated with seasoned non-agency IO. However, as delinquency rates in these pools increase, all else equal, the value of the collateral should fall, pushing a par clean-up call option further out of the money.

john.killian@santander.us 1 (646) 776-7714

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