By the Numbers
Growing amounts of agency loans look primed for PLS
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.
An analysis of loans recently delivered to Fannie Mae and Freddie Mac shows that more than a third would have had better pricing if they went into a private-label securitization. The combination of tightening PLS spreads and higher GSE fees for borrowers that refinance their loans appear to be the biggest drivers of improved PLS execution. And recently implemented caps on the amount of loans an originator can deliver to the GSEs cash windows could push more GSE-eligible production into private-label MBS as well.
A look at different collateral stories pooled by the GSEs in December shows, based on a handful of assumptions, that up to 37% of those loans could have achieved a higher price by aggregating and pooling into PLS later. More than half of the jumbo conforming and cash-out refinance loans delivered to the GSEs would have attracted a higher price in PLS. Agency-eligible investor and high FICO cohorts looked to have large swaths of loans that could have been delivered into private-label execution as well.
The issue of private-label best execution has always been a bit tricky as originators historically have often been willing to give up some economics associated with PLS in exchange for the consistent liquidity provided by the GSEs. Additionally, the GSEs require originators to sell them a representative sample of their production, limiting their ability to pick and choose which loans should go to private-label instead of GSE execution.
However, recent changes to agreements between the Treasury Department and the Federal Housing Finance Agency could limit the amount of liquidity that the GSEs may provide to any single originator, likely paving the way for more agency-eligible loans to flow into private-label trusts. According to recent amendments to the Preferred Stock Purchase Agreements, beginning in January of next year a lender can only deliver $1.5 billion of eligible collateral to the GSEs’ cash windows cumulatively over four consecutive quarters. In addition to limiting the amount of loans that can be delivered to the GSEs, other factors may push more collateral to the private market. Higher balance loans may not be deemed to be part of the core mission of the GSEs and continued efforts to de-risk the GSEs’ guaranty books of business may push more loans deemed to be riskier, such as cash-out refinances and those backed by investment properties to PLS.
A model for best execution
Estimating the part of GSE production that would have seen better pricing in PLS is no small undertaking as there are a range of relevant factors. Some of the key drivers include the following;
- Specified agency pool pay-ups
- The ‘AAA’ bond price spread to its TBA benchmark
- Risk-based GSE pricing for given loan attributes
- The value of interest in excess of or less than the fixed-rate bond coupon
- The amount and cost of credit enhancement required for a given loan, and
- Fixed costs associated with private-label issuance
All of these weigh on whether a loan would get a higher price in PLS or agency execution.
And while all these variables will factor into best execution, fundamentally loans will flow from one channel to another based on how credit enhancement is both funded and valued. Credit enhancement on loans that flow to the GSEs is funded through the loan’s interest in the form of a running guarantee fee while credit enhancement in PLS is funded through principal subordination. As valuations on the principal and interest components of a loan change, best execution will change along with those valuations. Given this, the amount of loans that get better pricing in PLS can change materially if the valuations on the principal and interest components of the mortgage loans do so as well.
Additionally, any best execution analysis may be affected by the timing mismatch and subsequent costs associated with owning interest rate and credit risk longer for PLS delivery than delivery to the GSEs. Elevated rate volatility could exacerbate the impact of the timing mismatch between locking and securitizing loans as costs associated with hedging interest rate risk may be underestimated, potentially skewing the analysis in favor of PLS execution to some extent.
With that said, two factors that appear to be the primary drivers of better private label execution are the tightening of spreads across private-label credit but particularly those of super-senior pass throughs relative to their TBA benchmarks as well as recent GSE loan-level pricing adjustments levied against refinanced mortgages. Additionally, valuations on interest-only bonds stripped off the ‘AAA’ pass-through classes have become a more material factor recently in private-label issuance as the amount of interest stripped off of pass-through classes is much greater now than it has been historically.
Sizing up best execution
Once a framework is in place for all these factors, the final piece of the puzzle is assigning a spread at which the ‘AAA’ pass-through will price behind its TBA benchmark. Admittedly, using a single spread for all collateral stories does not reflect the valuations assigned to these loans had they been delivered to the GSEs, but it is the current pricing convention for private-label pass throughs. Assuming the ‘AAA’ pass-through class prices at 24/32s behind its TBA benchmark, an estimated 54% of conforming jumbo and cash-out refinances delivered to the GSEs in December would have garnered at least a $0.25 better price through PLS with an average price roughly $0.50 better.
Seeing as loans often exhibit more than one of the attributes listed above, best execution is calculated based on a hierarchy of loan attributes starting with conforming jumbo and working through other stories. As such, all designations may have some population of story collateral beneath them in the taxonomy but none in the cohort above them. For example, the investor cohort has no jumbo loans but 22% of the loans are cash-out refinances.
Breaking down best execution
After assigning a population of loans to either private-label or GSE execution, those populations can then be analyzed to discern how the pools differ and what attributes may be driving private-label best execution.
Across almost all stories, loans that went to PLS execution had lower WACs, higher FICOs and lower LTVs and DTIs than those that went the GSE route. This is likely attributable to a pair of factors:
- Interest stripped off the same loan will garner a higher multiple in agency execution than it will in private-label space and as such, higher WAC loans should flow to agency execution.
- Rating agency subordination models are substantially more granular than the GSEs LLPA grids and, as a result, should give more credit to these loan attributes in the form of lower amounts of discounted credit enhancement, swinging the value proposition in favor of private label issuance.
Ultimately, best execution between private-label and GSE channels will ebb and flow based on a number of factors. Historically, the population of loans delivered to the GSEs that would have been better executed in PLS tended to range from 5% to 15%, and based on that last December’s production seems to be somewhat of an anomaly. With that said, there are certainly factors that were not in place historically that could push more loans into PLS. Caps on cash window delivery and broad-based levies on refinances appear to potentially be the most impactful.
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