By the Numbers

CMO issuance and the yield curve and dollar roll myth

| August 12, 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. This material does not constitute research.

Absolute agency CMO production in July dropped to one of its lowest levels in years, likely stirring up conversation in some parts of the market about the impact of the flatter yield curve and the implications for TBA dollar rolls. But conventional wisdom that a flatter curve hurts CMO production and, in turn, softens the TBA dollar rolls does not hold up on close inspection. It is a case of correlation but not causality. CMO production as a share of newly issued MBS pools has run relatively steady for years through steep and flat curves. And that tells a very different story about what to expect in CMOs and dollar rolls ahead.

As MBS pool production goes, so goes CMO issuance

CMO production in July fell 13.3% month-over-month and is 57.9% below January’s volume. But this year, as it has for years, issuance of new CMOs has closely tracked the gross issuance of new agency MBS. In the five years before to the pandemic, for example, both pool and CMO supply ran at roughly steady levels (Exhibit 1). CMO production bounces around more than pool production since structuring desks can accumulate pools over more than one monthly issuance cycle before creating a deal, but otherwise both series were relatively range-bound during those years. When refinancing picked up in the second half of 2019, so did CMO production. And when refinancing boomed during the pandemic, so did CMO production. Both pool and CMO issuance have been falling since early 2021, and the slowdown has continued as interest rates have headed higher this year.

Exhibit 1: CMO issuance closely tracks pool supply

Source: Fannie Mae, Freddie Mac, Ginnie Mae, Amherst Pierpont Securities

Calculating the percentage of new pool supply that is locked into CMOs each month makes the trend even clearer. For much of the last seven years, including during the pandemic, CMO desks absorbed 10% to 15% of monthly pool supply. Those percentages held through periods of greater and lower absolute CMO activity. For example, CMO issuance share jumped to around 17% for a few months in early 2018 and dropped below 10% for a few months in 2021. The red line is a simple regression to show that there has been a long-term downward trend.

Exhibit 2: CMO issuance is a relatively constant share of pool supply

Note: The light-blue line is the actual percentage each month. The dark-blue line filters out monthly noise and a small amount of annual seasonality The smoothed line was created using a Butterworth filter. The trend line is a simple linear regression.
Source: Fannie Mae, Freddie Mac, Ginnie Mae, Intex, Amherst Pierpont Securities

The explanation for the pattern of absolute and percentage CMO issuance is straightforward: investors that own CMOs routinely replace them as they pay down. When interest rates fall and prepayment speeds increase, investors need to replace prepaid CMO balances with new ones. Pool issuance increases at the same time as newly refinanced loans get re-pooled. A CMO investor could potentially decide to replace the CMO investment with pass-throughs, non-agency MBS, CMBS, or some other asset class. But the data suggest investors routinely reinvest in CMOs presumably because the cash flow profile, credit, liquidity or some other attribute of CMOs is well suited to their portfolio. In other words, a roughly steady proportion of MBS investors use CMO structure to tailor cash flows to their portfolio needs.

The myth of CMO production and the yield curve

These results challenge the conventional wisdom that CMO production depends on a steep yield curve to allow CMO structuring desks to sell short cash flows at high prices. If a steep curve raised CMO demand or improved profits from structuring, then CMO share of new pools would rise in a steep curve and fall in a flat one. But that clearly is not the case, at least over the last seven years when the curve has been both steep and flat at different times and CMO share has nevertheless been steady (Exhibit 3).

Exhibit 3: CMO share of pool issuance bears little resemblance to curve slope

Source: Fannie Mae, Freddie Mac, Ginnie Mae, Amherst Pierpont Securities

It is easy to see where a casual observer would draw a link between the curve and CMOs. Yield curve slope is clearly aligned with prepayments and absolute CMO production volume (Exhibit 4). That alignment likely comes from the tendency of the yield curve to steepen as rates fall, most often as the market anticipates Fed easing into a slower economy. The observer sees a steeper curve and higher CMO production. But the steeper curve is likely a sideshow to lower rates, higher prepayments and the need for CMO investors to replace prepaid balances. If rates ever dropped with the yield curve flatter, CMO production presumably would also rise.

Exhibit 4: Absolute CMO production is roughly aligned with yield curve shape

Source: Fannie Mae, Freddie Mac, Ginnie Mae, Amherst Pierpont Securities

A thought on dollar rolls

CMOs clearly play an important role the dynamics of the TBA dollar roll. Since CMOs buy pools and take delivery, they lower the floating supply of pools available to cover TBA sales. To draw out pools from current MBS holders and replenish supply, trading desks that have made TBA sales need to offer a higher dollar roll drop. Some investors might assume higher CMO production goes hand-in-hand with a higher dollar rolls and more aggressive financing for MBS. That may be true in certain periods where CMOs buy an extraordinarily high or low share of new production. But the historically relatively steady CMO share of new pools suggests CMOs exert a steady influence on dollar rolls whether absolute CMO production is high or low. It is CMO share, not absolute production, that makes the key difference in dollar rolls.

Some important twists in the latest CMO numbers

CMO production and pool production fell in July. However, Ginnie Mae CMO issuance increased. This is partially explained by difference in pool production across the agencies—Ginnie pool issuance was flat, while conventional issuance dropped. But heavy Ginnie CMO issuance also likely reflects shifting bank demand. Banks have preferred Ginnie Mae securities for much of the year since they receive better capital treatment. That is helpful for banks facing unrealized losses on MBS positions because of higher interest rates. Heavier buying of Ginnie pools for CMOs could keep Ginnie rolls strong while conventional rolls weaken.

Brian Landy, CFA
brian.landy@santander.us
1 (646) 776-7795

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.

The Library

Search Articles