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
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
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
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