By the Numbers

GSE caps on investor loans should push more to PLS

| March 19, 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. This material does not constitute research.

Caps on originators’ ability to sell loans to Fannie Mae and Freddie Mac backed by investor properties and second homes may speed their flow into private securitizations. GSE originations seem well suited for private-label execution as both WACs and LTVs have continued to fall across investor pools. And the private market could fund an even greater flow if it more efficiently prices the convexity found in investor loans.

Sizing up the non-owner occupied market opportunity

The recently revised Preferred Stock Purchase Agreements between the Federal Housing Finance Agency and the Treasury Department put limits on the amount of certain loans Fannie Mae and Freddie Mac can buy from a given originator. The caps apply to non-owner-occupied loans and loans with layered risks based on a combination of LTV, the borrowers’ credit score and debt-to-Income ratio as well as other factors. Originators are capped on sales of non-owner-occupied loans at 7.0% of total year-to-date origination volumes. And while many market participants expected these caps to go into effect in January next year along with other limits on cash window delivery, Fannie Mae’s recently revised guidance put these caps into effect starting June 1 of this year.. Freddie Mac has yet to issue comparable guidance but since the caps are mandated by FHFA, the agency should have its eye on eventual compliance.

There is some chance the PSPA amendments could get rolled back if the Supreme Court rules in Collins v. Mnuchin that current FHFA Director Mark Calabria can be replaced before the end of his 5-year term. That would require action by a new director appointed by President Biden and agreement from Treasury Secretary Yellen. Since the decision will likely come down only in early summer, originators still have to consider the prospect of complying with the caps.

Looking at the past eight quarters of GSE production, non-owner-occupied loans comprised less than 7.0% of gross originations only in the second quarter of last year during the peak impact of the pandemic. Breaking down each enterprise’s production, Fannie Mae’s total production of loans backed by second homes and investor properties only fell below the threshold once in the past two years while Freddie Mac’s fell below the cap twice in the second and third quarter of last year. Also, investor properties and second homes tend to make up a larger share of purchase than refi loans—11% of purchase loans last year compared to 6% of refis—so the pending caps may have even more impact as the market transitions toward more purchase originations

Within the category of non-owner-occupied loans, investor loans tend to make up more than half of Fannie Mae’s non-owner-occupied originations while Freddie’s production skews slightly more towards second homes, especially in more recent quarters (Exhibit 1). Based on current level of production, both enterprises would have exceeded these caps through the combination of investor properties and second homes in most quarters over the past two years. Additionally, these caps are calculated at the originator level, so even if the enterprises do not exceed these caps in aggregate, there are likely many originators who will find themselves over their individual caps and may need to tap the private-label securities market to fund their production.

Exhibit 1: Breaking down NOO loans across Fannie Mae and Freddie Mac

Source, Fannie Mae, Freddie Mac, eMBS, Amherst Pierpont Securities

Best execution

A best execution analysis of investor loans delivered to the enterprises in December shows that just over one third of those loans would have been better executed in a private-label deal. And a comparison of the attributes of loans that fetched better agency execution versus those that achieved a higher PLS price shows that higher WAC, higher LTV loans generally achieved better agency execution, likely for a number of reasons. First given the fact that loans will achieve a higher multiple for the same interest cash flow in agency space versus private-label, that pricing difference will be more meaningful in higher WAC loans where more interest is stripped off the loan relative to the pass-through rate.

In addition to higher IO multiples in agency space, higher coupons allow for higher WAC loans to be executed into higher coupon specified pools which garner higher pay-ups. Comparing the average pay-up on the 3.45% GWAC cohort that garnered better GSE execution versus the 3.04% GWAC cohort that was better executed in PLS shows that, on average the GSE loans fetched an average pay-up of 2.56 points while the lower GWAC PLS loans only would have averaged a pay-up of 1.21 points over TBA. Higher pay-ups also facilitated better GSE execution in that they served to offset larger LLPAs associated with higher LTV investor properties. Conversely, lower LTV loans benefitted from PLS execution as they, on average, only required an estimated 4.5% of subordination for the remainder of the cash flow to be rated ‘AAA’ versus an estimated 13.5% points of subordination for higher LTV loans that achieved better GSE pricing.

Looking at the attributes of investor loans recently delivered to the enterprises shows that much of their recent production is comprised of lower WAC lower LTV loans that may find a home in private-label deals if they begin to curtail their purchases. In the fourth quarter of last year, the enterprises collectively originated over $36 billion of investor loans, representing slightly less than 5% of their total issuance. The loans had an average LTV of 63 and an average WAC of 3.32% suggesting that a considerable swath of these loans could be securitized efficiently in private-label deals. Obviously fueled in no small part by the rally in interest rates, average WACs, and LTV ratios across investor loans issued by the agencies have both come down over time, potentially setting up for a smooth transition for the private market to take some share of this production (Exhibit 2).

Exhibit 2: Average WACs and LTVs decline across GSE investor loans over time

Source: Fannie Mae, Freddie Mac, eMBS, Amherst Pierpont

Setting the stage for more private-label issuance

The private-label market may need to mature fairly quickly to absorb the potential overflow of supply in excess of the GSE caps. One apparently glaring weakness in the PLS market when it comes to investor collateral is that while pools backed by investor loans trade to, in some cases, multiple point premiums over TBA in the agency market, the private-label market tends to paint all collateral with the same brush. Private-label pass-throughs backed by investor loans still price back of TBA and often only slightly tighter than pools backed by more negatively convex non-conforming or conforming jumbo collateral. And while the private-label, shifting-interest structure will make the pass-through cash flow more levered than a specified pool, especially in the case where there is significant amounts of enhancement below the ‘AAA’ super-senior class, this structural leverage should not justify such a steep spread concession. However, this pricing inefficiency may prove to be a powerful motivating factor in attracting more capital to PLS pass-throughs backed by investor loans.

As potential supply from the GSEs begins to be absorbed the market may become more efficient in terms of pricing the convexity in investor collateral. Based on several assumptions, it’s estimated that roughly 36% of investor loans delivered to the enterprises in December would have achieved a minimum of a quarter point higher price had they been sold into a private-label deal. Changing one of those assumptions, namely tightening the spread at which the ‘AAA’ pass-through is priced at, by half a point, would increase the amount of investor loans better executed in PLS to 47% of the GSEs December production. And while any transition in funding these loans from the GSEs to private channels may not be seamless, the fact that the private market continues to price these loans inefficiently coupled with the fact that GSE originations appear to square up with private-label execution may facilitate a reasonably smooth one.

Chris Helwig
chelwig@apsec.com
chelwig

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