Smaller loans drive speeds and valuations in prime MBS
admin | July 31, 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.
Prepayments in prime jumbo MBS came in hot in July, but the driver of those speeds may come as a surprise: smaller loans. Loans with lower balances prepaid faster than loans with higher balances. Low conforming mortgage rates and elevated jumbo mortgage rates along with fewer refinancing frictions for smaller loans appear to be behind the speeds. The prepayment shift should soften valuations in senior classes of deals backed by conforming loans, but faster speeds should also deleverage these deals and potentially lift valuations in the investment grade mezzanine debt.
Rates and refi frictions reshape prepayment risk
The jumbo market may be in the midst of a sea change in the convexity profile of loans backing prime trusts. Given the same amount of refinancing incentive, loans with higher balances see a larger absolute reduction in monthly payment and historically have prepaid faster. However, loans in the prime jumbo market with large agency-eligible balances (jumbo conforming) now exhibit steeper S-curves than loans with small agency-eligible balances (conforming) and loans with non-conforming balances (jumbo non-conforming) (Exhibit 1).
Exhibit 1: Agency-eligible jumbo loans in PLS trusts exhibit the steepest S-curves
The disparity between jumbo conforming and jumbo non-conforming speeds widens as the refinancing option becomes more in-the-money. At 50 bp of refinancing incentive, conforming jumbo loans prepay about 6 CRR faster than non-conforming ones. That difference increases to roughly 10 CRR once the borrower’s option is 100 bp or more in-the-money.
Jumbo non-conforming speeds likely reflect the recent decoupling between conforming and non-conforming rates as non-conforming rates have risen above conforming ones recently. Comparing the Freddie Mac PMMS rate to the weekly Bankrate national jumbo mortgage rate since the beginning of March shows that the jumbo rate on average has been roughly 40 bp higher than the conforming rate.
In addition to higher rates, non-conforming borrowers likely have fewer potential channels to refinance their loans. Redwood Trust, a historically prominent buyer of non-conforming loans, has just recently begun purchasing loans after pausing due to Covid-19 market disruptions. Additionally, large bank issuers limited originations to only their retail channels in response to market volatility, further limiting refinancing capacity for non-conforming borrowers. Conversely, programs put in place by the GSEs to reduce frictions to refinancing in response to the pandemic have likely made refinancing easier for borrowers with balances that meet conforming limits.
Some of the fastest prepayment speeds in July came in trusts backed by seasoned loans where borrowers have had significant amortization or curtailment of their loan balances, likely lowering once non-conforming balances below the threshold of the GSE jumbo conforming limits. Breaking down the prime jumbo 2.0 universe by vintage and balance shows that conforming jumbo speeds were elevated irrespective of seasoning and were above 50 CRR for almost all vintages absent the 2019 and later cohort (Exhibit 2).
Exhibit 2: Jumbo conforming speeds elevated across vintages in July
Some vulnerable deals
Given this, pools with large concentrations of jumbo conforming loans coupled with significant refinancing incentive may likely be susceptible to continued elevated prepayment rates. Some examples of these deals are JPMMT 2018-9 and 2019-1. As of the July remittance, the 2018-9 deal has a 4.57% GWAC and 66% of the loans are jumbo conforming based on current loan size and geography. The deal prepaid at roughly 55 CRR this month. The 2019-1 transaction has a 4.63% GWAC and 59.6% of the collateral has a jumbo conforming balance with an additional 11.7% of conventional conforming loans. The deal paid just less than 60 CRR in July. This profile is not unique to the JPMMT shelf as certain GSMBS, FSMT and WFMBS deals have similar collateral characteristics and may be also be exposed to elevated prepayment rates for the foreseeable future. (Exhibit 3)
Exhibit 3: Scanning the prime 2.0 universe for high WAC jumbo conforming loans
Implications for valuation
While these elevated speeds have yet to have an impact on spreads, it certainly appears they should. To the extent that elevated speeds are increasing negative convexity and option cost, ‘AAA’ pass-throughs will underperform on a total return basis relative to their TBA benchmarks into a rally or sell-off. If speeds remain elevated on conforming jumbos, higher coupon, 2018 and 2019 vintage pass-throughs should show the greatest amount of nominal widening as the value of the incremental IO gets compressed, potentially to a point where the incremental 50 bp of IO on higher coupon bonds could trade flat to lower coupon pass-throughs especially in light of already compressed coupon swaps in higher coupon TBA benchmarks. Declining IO valuations may also have an impact on new issue arbitrage as well. Investors will likely maintain conservative valuation multiples, especially on deals that come to market with large populations of jumbo conforming loans, potentially making PLS execution less viable. However, this phenomenon may be somewhat self-policing in the PLS market as it seems likely that the loans that can find their way to agency execution will likely be headed to that channel rather than through PLS execution in the near term.
Potential beneficiaries of these fast speeds are investment grade mezzanine tranches of prime 2.0 trusts. With the obvious caveat that overall delinquency rates on prime jumbo collateral are roughly in-line with the detachment point of the subordinate stack and that capitalization and deferral modifications are already eroding credit enhancement in some 2.0 trusts, these fast speeds will serve to de-lever the subordinate stack. And given relatively low mark-to-market LTVs across the majority of prime 2.0 trusts, loss severities should remain low on those loans that ultimately do roll to default and liquidate, suggesting that credit enhancement may continue to build on these bonds, potentially enhancing their return profile.