Uncategorized
Broker loans boost negative convexity in prime 2.0
admin | April 9, 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.
Large populations of prime jumbo loans coming through broker or warehouse channels are lifting prepayment speeds in new private-label deals and may show slower speeds out-of-the-money, increasing deal negative convexity. Deals heavy concentrated in these loans should trade at wider spreads to account for the greater option cost, although investors looking for carry may find opportunity in deals that have dropped out of the refi window.
Analyzing the effect of TPO loans in prime 2.0
An analysis of fixed rate loans backing post-crisis prime securitizations shows that given the same amount of refinancing incentive after adjusting for any risk based pricing or SATO on a given loan, those originated through broker or wholesale channels have historically prepaid faster than loans originated through retail channels when in-the-money and slower when further out-of-the-money. (Exhibit 1)
Exhibit 1: Broker and wholesale loans exhibit steeper S-curves in prime 2.0
Source: CoreLogic, Intex, Amherst Pierpont
The difference in speeds between retail and broker or wholesale channels is most pronounced when loans are either at or slightly in-the-money or when loans are further out-of-the-money. Loans originated through broker or wholesale channels tend to prepay roughly 5 CRR faster than those originated through retail channels when either at-the-money or 25 bp in-the-money and 10 CRR slower when 50 bp out-of-the-money. While it’s difficult to say with certainty what may be driving these differences, it seems plausible that broker and wholesale channels may be more operationally efficient in refinancing loans with small amounts of refinancing incentive driving faster speeds on loans that are slightly in-the-money. Conversely, as loans fall out of the money and refinancing volumes decrease, broker and wholesale channels may be more focused on originating higher margin products like expended credit or non-QM loans against the backdrop of tighter primary secondary mortgage spreads, decreasing gain-on-sale margins and lower volumes in higher credit quality borrowers.
Loans originated through broker and wholesale channels with conforming jumbo balances that could potentially be refinanced in an agency execution may be the most negatively convex of those originated through these channels as they exhibit steeper S-curves than those of loans with both higher and lower balances. This is consistent with broader trends in prime 2.0 over the past year in that despite greater savings given the same amount of refinancing incentive, loans with non-conforming jumbo balances have prepaid slower than those with jumbo conforming balances. This is likely largely attributable to lower frictions to refinancing associated with loans that could have gone to agency execution over the past year as channels to refinance larger balance loans narrowed due to broader pandemic related market disruptions. However, this phenomenon may continue to hold up into the future across loans originated through broker and warehouse channels as broker networks may be more attune to private label to agency cross-refinancing options for borrowers (Exhibit 2).
Exhibit 2: Jumbo conforming TPO loans exhibit the steepest S-curves
Source: CoreLogic, Intex, Amherst Pierpont
Given this, scanning for deals with large amounts of TPO loans with conforming balances and GWACs that are roughly at or slightly in the money may provide a useful guidepost for deals that may exhibit worse convexity going forward while deals with lower concentrations of TPO loans may exhibit better convexity all else equal. (Exhibit 3)
Exhibit 3: Scanning the prime universe for TPO and conforming balance loans
Source: CoreLogic, Intex, Amherst Pierpont
Percentages are measured based on collateral composition at deal closing
Deals with larger concentrations of both TPO and conforming balance loans are largely seasoned Flagstar trusts and 2019 and 2020 vintage JPMMT deals backed by both conventional and high LTV collateral. The impact of higher concentrations of TPO loans may be more pronounced in trust backed by conventional collateral than in high LTV deals as high LTV loans, especially those with LTVs greater than 90, have generally exhibited flatter S-curves and slower prepayment rates. Conversely, certain WFMBS, Pearl Street and seasoned transactions issued by a number of sponsors have relatively small amounts of TPO and conforming balance loans and are substantially less exposed to this phenomenon.
Investment implications
While the market does not currently price in the presence of higher TPO, more negatively convex collateral it likely should, as investors should require more nominal spread to account for the greater option cost associated with the greater negative convexity. While growing amounts of negative convexity may drive broad based spread widening in higher TPO pools, it may create opportunity in certain cash flows. Given the recent amount of issuance backed by lower WAC, out-of-the-money collateral, investors may target higher coupon pass-throughs or derivatives in deals stocked with large amounts of loans originated through broker or wholesale channels. The combination of almost non-existent out-of-the-money speeds coupled with a steep forward curve predicting higher forward mortgage rates may have the combined effect of dampening prepayment rates and driving enhanced carry. The obvious caveat is that carry may decrease on inverse IO against the backdrop of higher forward rates.
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 © 2024 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.
Important disclaimers for clients in the EU and UK
This publication has been prepared by Trading Desk Strategists within the Sales and Trading functions of Santander US Capital Markets LLC (“SanCap”), the US registered broker-dealer of Santander Corporate & Investment Banking. This communication is distributed in the EEA by Banco Santander S.A., a credit institution registered in Spain and authorised and regulated by the Bank of Spain and the CNMV. Any EEA recipient of this communication that would like to affect any transaction in any security or issuer discussed herein should do so with Banco Santander S.A. or any of its affiliates (together “Santander”). This communication has been distributed in the UK by Banco Santander, S.A.’s London branch, authorised by the Bank of Spain and subject to regulatory oversight on certain matters by the Financial Conduct Authority (FCA) and the Prudential Regulation Authority (PRA).
The publication is intended for exclusive use for Professional Clients and Eligible Counterparties as defined by MiFID II and is not intended for use by retail customers or for any persons or entities in any jurisdictions or country where such distribution or use would be contrary to local law or regulation.
This material is not a product of Santander´s Research Team and does not constitute independent investment research. This is a marketing communication and may contain ¨investment recommendations¨ as defined by the Market Abuse Regulation 596/2014 ("MAR"). This publication has not been prepared in accordance with legal requirements designed to promote the independence of research and is not subject to any prohibition on dealing ahead of the dissemination of investment research. The author, date and time of the production of this publication are as indicated herein.
This publication does not constitute investment advice and may not be relied upon to form an investment decision, nor should it be construed as any offer to sell or issue or invitation to purchase, acquire or subscribe for any instruments referred herein. The publication has been prepared in good faith and based on information Santander considers reliable as of the date of publication, but Santander does not guarantee or represent, express or implied, that such information is accurate or complete. All estimates, forecasts and opinions are current as at the date of this publication and are subject to change without notice. Unless otherwise indicated, Santander does not intend to update this publication. The views and commentary in this publication may not be objective or independent of the interests of the Trading and Sales functions of Santander, who may be active participants in the markets, investments or strategies referred to herein and/or may receive compensation from investment banking and non-investment banking services from entities mentioned herein. Santander may trade as principal, make a market or hold positions in instruments (or related derivatives) and/or hold financial interest in entities discussed herein. Santander may provide market commentary or trading strategies to other clients or engage in transactions which may differ from views expressed herein. Santander may have acted upon the contents of this publication prior to you having received it.
This publication is intended for the exclusive use of the recipient and must not be reproduced, redistributed or transmitted, in whole or in part, without Santander’s consent. The recipient agrees to keep confidential at all times information contained herein.
