By the Numbers

Evaluating call upside in legacy RMBS

Chris Helwig | February 26, 2021

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 RMBS market is somewhat of an anomaly in that a significant amount of the universe still trades at a discount to par. Investors that own discount bonds issued by trusts likely to get called stand to gain from having the call exercised and the bonds paid off at par. Low interest rates coupled with tightening credit spreads have helped to drive the value of the loans backing legacy trusts higher, resulting in an estimated $50 billion in legacy collateral trading at a premium. Many trusts consequently have become more callable.

Sizing up the call opportunity associated with legacy trusts starts with estimating the average price of the loans underlying the trusts as the calls are struck at par on the loans. Deals backed by premium collateral should be callable assuming the pool has paid down sufficiently to push the pool factor below the level where the call owner can execute. Estimating the price of the collateral backing legacy trusts requires assumptions about future pool performance, the implied spread at which the collateral trades as well as other key assumptions. Holders of legacy call rights also can reduce the effective strike on the call option of a given trust below par buy purchasing discount bonds, covering losses from calling discount loans at par with profits from calling discount bonds at par. After reviewing those factors, it appears the potential upside to legacy trusts being called may be substantial.

Amherst Pierpont estimates that the legacy universe currently trades at a modest discount to par with an average price of just below $97 with some cohorts trading at a steeper discount. Cleaner, shorter cohorts with lower expected losses trade to higher average dollar prices while longer pools with higher expected losses such as subprime and Option ARM loans have lower estimated valuations. In aggregate, the legacy universe is well below the collateral clean-up strike of 10% as the universe has an average deal factor of 8.2% with all cohorts below the 10% threshold (Exhibit 1).

Exhibit 1: Estimating the value of the legacy universe

Source: CoreLogic, Amherst Pierpont Securities

Given this, any attempt to extract upside from called deals needs to be somewhat targeted. An estimated roughly 20% of legacy collateral analyzed, or just over $50 billion, trades at a premium at the deal level. Including pools that trade at less than a point discount to par adds an additional $12 billion of collateral that could be callable if non-performing loans in those deals were to cure or liquidate, or if rates were to fall and push up prices.

Breaking down premium collateral by sector shows that the cohort with the greatest potential upside to call is legacy Alt-A, which makes up more than 40% of premium legacy loans. Alt-A loans also carry the highest weighted average price at almost a 4-point premium over par. And with an estimate duration of 3.6 years, some or all of the 454 legacy Alt-A deals that make up this cohort may still be in-the-money even if rates continue to back up. Conversely, there appears to be virtually zero upside to call in the Option ARM cohort absent lowering the effective call strike through the purchase of discount bonds. Since Option ARM collateral is floating-rate and short-duration, unless the coupon has been modified, the cohort likely saw limited price appreciation from lower interest rates in the last year (Exhibit 2). While the prime cohort contains a large amount of premium collateral, the opportunity for call upside may be limited as cleaner mezzanine and subordinate bonds may not trade at an appreciable discount to par.

Exhibit 2: Alt-A and prime cohorts have the largest amounts of premium loans

Source: CoreLogic, Amherst Pierpont Securities

Looking at the opportunity at the shelf level shows the most meaningful opportunity resides in legacy Countrywide shelves, which across the CWALT and CWHL shelves have nearly $11 billion in premium collateral backing those trusts. In addition to premium price, holders of call rights on legacy trusts may have incentives to call collateral with greater interest rate duration sooner. Given the call rights are tied to the loans, their value will decline as interest rates rise and the value of the collateral falls below the par call strike. As a result, holders of call rights may have greater incentive to call deals backed by loans with longer rate durations sooner as they will become less callable as rates rise. If that is the case, then deals issued off of shelves like ACCR and HEAT may be likely call candidates as the premium loans backing those trusts have more interest rate risk than others (Exhibit 3).

Exhibit 3: Certain shelves have greater pockets of premium collateral

Source: CoreLogic Amherst Pierpont Securities – Top 10 shelves sorted by balance

Another shelf that has a significant amount of premium priced collateral with relatively long duration is the WMALT shelf. But collateral price and rate duration are not the only considerations when thinking about whether a legacy deal may be called or not. Another consideration is where the call rights reside and whether the holder of the rights is likely to execute the call. And while it’s virtually impossible to know where all the call rights on legacy trusts reside some assumptions can be made as to whether the holder is likely to execute the call. In the case of the WMALT shelf, the call rights likely transferred to JPMorgan through their acquisition of Washington Mutual. And to date, JPMorgan has not actively executed calls on legacy trusts. Therefore legacy trusts serviced by JPMorgan, including Washington Mutual and Bear Stearns shelves, may be less likely to be called than others despite the fact that the collateral may be in-the-money.

While size of the opportunity is one metric for targeting shelves with upside to call, scanning for deeper in-the-money options may be another as deals with loans that trade to substantial premiums over par should be more likely call candidates all else equal. Scanning for shelves with significant premiums and a reasonable amount of callable collateral shows shelves like IMSC, IMJA, MALT and MSAC may be subject to elevated call activity in the coming months (Exhibit 4).

Exhibit 4: Call options deeper in the money on certain legacy shelves

Source: CoreLogic, Amherst Pierpont Sample limited to shelves with ~$100MM in premium collateral balance

Chris Helwig
chelwig@apsec.com
chelwig

This material is intended only for institutional investors and does not carry all of the independence and disclosure standards of retail debt research reports. In the preparation of this material, the author may have consulted or otherwise discussed the matters referenced herein with one or more of SCM’s trading desks, any of which may have accumulated or otherwise taken a position, long or short, in any of the financial instruments discussed in or related to this material. Further, SCM may act as a market maker or principal dealer and may have proprietary interests that differ or conflict with the recipient hereof, in connection with any financial instrument discussed in or related to this material.

This message, including any attachments or links contained herein, is subject to important disclaimers, conditions, and disclosures regarding Electronic Communications, which you can find at https://portfolio-strategy.apsec.com/sancap-disclaimers-and-disclosures.

Important Disclaimers

Copyright © 2023 Santander US Capital Markets LLC and its affiliates (“SCM”). All rights reserved. SCM is a member of FINRA and SIPC. This material is intended for limited distribution to institutions only and is not publicly available. Any unauthorized use or disclosure is prohibited.

In making this material available, SCM (i) is not providing any advice to the recipient, including, without limitation, any advice as to investment, legal, accounting, tax and financial matters, (ii) is not acting as an advisor or fiduciary in respect of the recipient, (iii) is not making any predictions or projections and (iv) intends that any recipient to which SCM has provided this material is an “institutional investor” (as defined under applicable law and regulation, including FINRA Rule 4512 and that this material will not be disseminated, in whole or part, to any third party by the recipient.

The author of this material is an economist, desk strategist or trader. In the preparation of this material, the author may have consulted or otherwise discussed the matters referenced herein with one or more of SCM’s trading desks, any of which may have accumulated or otherwise taken a position, long or short, in any of the financial instruments discussed in or related to this material. Further, SCM or any of its affiliates may act as a market maker or principal dealer and may have proprietary interests that differ or conflict with the recipient hereof, in connection with any financial instrument discussed in or related to this material.

This material (i) has been prepared for information purposes only and does not constitute a solicitation or an offer to buy or sell any securities, related investments or other financial instruments, (ii) is neither research, a “research report” as commonly understood under the securities laws and regulations promulgated thereunder nor the product of a research department, (iii) or parts thereof may have been obtained from various sources, the reliability of which has not been verified and cannot be guaranteed by SCM, (iv) should not be reproduced or disclosed to any other person, without SCM’s prior consent and (v) is not intended for distribution in any jurisdiction in which its distribution would be prohibited.

In connection with this material, SCM (i) makes no representation or warranties as to the appropriateness or reliance for use in any transaction or as to the permissibility or legality of any financial instrument in any jurisdiction, (ii) believes the information in this material to be reliable, has not independently verified such information and makes no representation, express or implied, with regard to the accuracy or completeness of such information, (iii) accepts no responsibility or liability as to any reliance placed, or investment decision made, on the basis of such information by the recipient and (iv) does not undertake, and disclaims any duty to undertake, to update or to revise the information contained in this material.

Unless otherwise stated, the views, opinions, forecasts, valuations, or estimates contained in this material are those solely of the author, as of the date of publication of this material, and are subject to change without notice. The recipient of this material should make an independent evaluation of this information and make such other investigations as the recipient considers necessary (including obtaining independent financial advice), before transacting in any financial market or instrument discussed in or related to this material.