By the Numbers
Higher LLPAs but little impact on speeds or value
Brian Landy, CFA | January 7, 2022
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.
Fannie Mae and Freddie Mac plan to increase guarantee fees for certain mortgages starting in April, but the likely impact on MBS speeds and valuations looks minimal. The biggest fee increase comes for second homes, where speeds could drop substantially. But these loans account for only 4% of production and are scattered across the pool universe, leaving most investors with little exposure. Fees also go up for loans with balances greater than the conforming loan limit. High balance loans accounted for 10% of production, with nearly 40% of those loans pooled separately. The effect of higher fees on jumbo pools is nevertheless muted by the jump in the conforming loan limit in 2022, since many loans could now refinance into a conforming loan and avoid the fees. Quick analysis shows that OASs on new 30-year jumbo pools should increase only 0.7 bp on 2%s and 1.8 bp on 2.5%s.
The fees take effect for all loans acquired by the GSEs starting in April. Lenders will need to start charging to loans that lock in rates before then to account for the time it takes to close a loan. Any effects on prepayment speeds and supply consequently should start having an impact before April.
The new loan-level price adjustment (LLPA) for second homes is much higher than the existing LLPA, which was zero below 85 LTV and only 0.25 points above (Exhibit 1). The table shows the old LLPA, the LLPA increase, and the new LLPA for each LTV category. The fees for investment properties, which did not change, are included for comparison. Under the new LLPA schedule the smallest fee is 1.125 points for loans below 60 LTV and as high as 4.125 points for loans above 80 LTV. The LLPA is identical to the investor LLPA for loans over 70 LTV. Speeds for any of these loans in existing pools should slow substantially since they will be farther out-of-the-money to refinance. However, it is difficult to take advantage of the opportunity, since these loans are a small part of Fannie Mae and Freddie Mac production and were not pooled separately.
Exhibit 1. LLPA change for second homes
The fees should have little impact on prepayments in new loans made against second homes. Note rates for second home loans should increase markedly when originators start collecting the LLPAs, offsetting the effect of higher fees, since most borrowers take out a higher rate loan to pay LLPAs. For example, assume the current mortgage rate is 3.10% for a primary residence and second home. After the fee increase the mortgage rate for a 75 LTV second home jumps to 3.67%. A loan for a second home originated at 3.10% will suddenly be 57 bp out-of-the-money to refi. However, a loan originated after the fee increase will have a 3.67% note rate and be at-the-money to refinance.
The higher fees could bolster the GSEs’ capital position and be used to finance other initiatives. However, the fees could drive some business to private markets. Last January the FHFA and GSEs attempted to cap the amount of second homes and investment properties guaranteed by the GSEs. Those limitations were very disruptive for originators and ultimately suspended in August. The new approach may achieve a similar result, albeit in a less disruptive fashion and without affecting investment properties. Financing second homes, often vacation properties, may not be viewed as part of the GSEs core mission. There could be opportunity for private-label securitization (PLS) execution if the new LLPAs are much higher than required to compensate for the credit risk in these loans. However, ratings agencies could view these loans as riskier and demand higher levels of subordination for a second home deal.
High balance loans
The fee charged to high balance loans is also increasing (Exhibit 2). The new LLPAs are 0.25 points to 0.75 points higher than the existing LLPAs. A borrower taking out a purchase or rate-and-term refinance loan over 75 LTV will need to pay 1 point upfront, and a cash-out refinance tops out at 1.75 points. High balance ARM loans over 90 LTV will have to pay an additional 0.25 points. Borrowers with incomes below 100% of the area median income will not have to pay the higher LLPA for high balance loans. However, few borrowers in the GSEs’ low-income lending programs take out high balance loans. The LLPAs for the various low-income lending programs—Fannie Mae’s HomeReady and HFA Preferred, and Freddie Mac’s Home Possible and HFA Advantage—remain unchanged.
Exhibit 2. LLPA change for high balance loans
Higher loan limits in 2022 were expected to divert loans from private execution to GSE execution, but the higher fees for GSE jumbo conforming execution could prevent some of this inflow.
Rate increase from higher LLPAs
Most borrowers will take out higher rate loans to pay for LLPAs, and the increase can be estimated using TBA prices (Exhibit 3). The rate for second homes should increase anywhere from 30 bp to 125 bp, depending on the LTV, so the effect could be quite large. The increase for high balance loans is smaller, ranging from 7 bp to 20 bp. The size of the elbow shift will change with market conditions. For example, if coupon swaps increase in value (a higher implied IO multiple) then the elbow shift will fall. The effect on second homes (and investment properties) is especially large since the LLPAs are so high.
Exhibit 3. Projected rate increase for fixed rate loans due to higher LLPAs (bp)
Valuation implications for jumbo conforming pools
Exploring the valuation effect on high balance loans is important since it is possible to source pools backed exclusively by high balance loans (Exhibit 4). Many high balance loans are delivered into TBA pools, but subject to a 10% de minimis limit. The rest are placed into jumbo conforming pools. The table shows how the high balance loans were pooled.
Using 2021 as an example, $1,752 billion in pools were outstanding on 12/1/2021. This includes TBA-deliverable pools and jumbo conforming pools. Of these loans, 10% were jumbo when they were pooled. But only 5.9% are jumbo after the loan limit increase in 2022. Many of these loans were put into TBA pools; 3.6% of the loans are in jumbo conforming pools. After the loan limit increase only 2.1% would need a jumbo conforming refinance. That means 59.3% [=2.1/3.6] of the loans in 2021 vintage jumbo conforming pools are still jumbo loans. Even fewer jumbo loans remain in older vintage pools.
Exhibit 4. Current distribution of high balance loans in conventional pools
Representative 2% and 2.5% pools were selected from the 2021 vintage to estimate the effect on valuations (Exhibit 5). The weighted average elbow shift was calculated for each pool using the loan size and current LTV distributions of each pool. Each pool was run twice at the current market price, once using Yield Book’s production model and once using the model dialed with the average elbow shift. The OAS increases by 0.7 bp on the 2% pool and 1.6 bp on the 2.5% pool.
Exhibit 5. Valuation effect of higher LLPAs on jumbo conforming pools
There are several reasons that the valuation effect is not very large. First, roughly 40% of the loans in the pools now qualify for conforming delivery so the jumbo LLPA is irrelevant. Second, high HPA has helped put many loans into the lowest LTV bucket with the smallest LLPA increase. Third, mortgage prices have fallen sharply recently, which reduces the value of slower refinance speeds. The effect would be even smaller for older vintages.
Another caveat to this analysis is that it assumes the GSEs have no competition. However, the GSEs face competition from private securitizations. Higher fees will make private label execution relatively more attractive and that could prevent mortgage rates for these loans from increasing as much as projected by higher LLPAs.
The FHFA’s announcement is here.
Fannie Mae’s Lender Letter is here.