By the Numbers
An opportune time for an FHA MIP cut
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.
Investors in Ginnie Mae MBS have long worried about another reduction in FHA mortgage insurance premiums or MIPs, which typically would drive a pickup in refinancing and hurt the value of MBS trading above par. This has been a significant concern since most of the market traded at a premium for the last two years. However, nearly all Ginnie Mae MBS now trade at a discount to par and the effect of dropping insurance premiums is much lower. But any new loans originated at today’s higher rates will carry substantial exposure to a premium reduction. If the FHA intends to lower premiums, now may be the best time for investors to accept the change.
The G2SF 2% TBA priced at $100-10+ on January 3, putting more than 99.5% of Ginnie Mae MBS above par. A cut in FHA insurance premiums would have increased refinance incentives and eroded the market value of these securities. For example, a 30 bp MIP cut would likely have erased roughly $3.0 billion market value of Ginnie Mae MBS (Exhibit 1). But lower MBS prices have pushed 96% of MBS below par and dropped the effect of a 30 bp MIP cut to $449 million.
Exhibit 1. Higher interest rates have muted the effect of a MIP cut
Note: The estimated change in market value and other security attributeds is for a 30 bp cut in MIPs.
Source: Yield Book, Amherst Pierpont Securities
The large 2.0% and 2.5% coupons now benefit from a MIP cut, since it could provide a marginal boost to turnover speeds. The 3.0%, 3.5%, and 4.0% coupons still lose some value since the OAS model assigns some probability that rates could fall and refinancing increase. But the value lost is much less than at the start of the year. A MIP cut lowers convexity, but for most coupons the drop is much less than at the start of the year.
It is important to note that a MIP cut is not guaranteed. The FHA is still assessing the outcomes of loans exiting Covid forbearance. And uncertainty around inflation and the economy might encourage the FHA to wait longer to assess the health of the insurance fund. On the other hand, strong home price appreciation has continued into 2022 and makes it easier to accommodate lower premiums.
If the FHA chooses to lower premiums, the amount is likely to be less than by 30 bp. A 30 bp cut would bring premiums back to the level preceding the 2008 financial crisis. But the fund went negative in the years following the crisis, providing real world experience that a 55 bp premium is insufficient to keep the fund solvent.
The other benefit of cutting premiums sooner rather than later is that newly issued pools will have greater exposure to a cut than most currently outstanding pools. An investor would prefer to buy a 4.5% pool with a 70 bp MIP than an 85 bp MIP. If many 85 bp MIP pools are issued before premiums are cut then there would be a larger effect on Ginnie Mae II TBA prices, which would ultimately raise rates for Ginnie Mae borrowers. Lowering MIPs before those loans can be originated should protect the value of the par coupon TBA.
Exhibit 2. A MIP cut has a larger effect on higher coupon TBA prices
Assumes 30 bp MIP cut for TBA backed by 85 bp MIP loans.
Source: Yield Book, Amherst Pierpont Securities
Production so far in 2022 has still been primarily in 3.5% and lower coupon pools that are no longer too exposed to lower premiums. Even the April multi-issuer pools are still dominated by loans in 2.5%, 3.0%, and 3.5% pools. But production will shift higher in the coming months—the prevailing FHA rate was 5.21% as of April 28, according to Optimal Blue’s rate lock index.
Finally, a MIP cut is never a benefit to investors in interest-only securities, which only lose cash flow when prepayment speeds increase. However, it still may be better to deal with a cut now that reduces the exposure to MIPs in new issue IOs backed by 4% and higher coupon pools.
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