The Big Idea

An opportunity to upgrade in MBS at scale

Steven Abrahams | May 5, 2023

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.

It may not be the equivalent of the Met or the Louvre or the Prado or the British Museum putting their collections on sale, but the current FDIC liquidation of bank MBS is an unprecedented opportunity for MBS investors to upgrade. A quick study of one money manager’s pass-through portfolio suggests that for every security now in position, dozens of pools coming out from the FDIC with substantial current balances could upgrade the quality of the book. And with the FDIC’s agent, BlackRock, announcing Friday that it would start on May 9 taking reverse inquiry for a pass-through auction scheduled for May 15, the window of opportunity is closing faster.

Silicon Valley Bank and Signature Bank bought pass-throughs mainly from 2020 through 2022. They collected across conventional and Ginnie Mae MBS, across 30-, 20-, 15-year and other maturities, mostly across coupons from 1.5% through 3.0% and in a range of specified pools—loan balance, geography, investor, FICO and loan purpose. Most of these pools are out of production. And now the whole collection is on sale. A list of remaining offerings is here. It is an offering of diverse pass-through exposures in amounts investors find rarely if ever.

Pass-throughs are easier to compare than paintings, and it seems almost certain that an MBS investor can find pools in the FDIC liquidations objectively better than the pools the investor now holds. Investors should swap out of the weaker pools in their position and into the better pools now in the FDIC pipeline as long as the difference in quality is enough to overcome some of the high bid-ask costs now in the market.

As proof-of-concept, one money manager provided Santander with a list of 1,041 pools held, holding back original and current balances to protect the confidentiality of the position. We ran analytics on each pool and on all the FDIC pending offerings as of May 3 and then calculated a few measures for each of the manager’s pools:

The number of FDIC pools with a better Treasury OAS
The current balance of pools with a better Treasury OAS
The number of pools with both a better OAS and zero-volatility spread
The current balance of pools with both a better OAS and zvol

The analysis showed the manager could take each current holding and choose from an average of dozens of FDIC pools with better OAS and nearly the same number with both better OAS and better zero-volatility spread. And those better pools came in rare size, with current balances across the better pools ranging from hundreds of millions of dollars to up to $5.3 billion. But it helps to look at some specifics.

The money manager’s portfolio held 733 pools of conventional 30-year MBS split across coupons from 2.0% through 8.0% (Exhibit 1). Most of the opportunity with the FDIC liquidations comes in lower coupons where the banks bought the most. In 30-year 2.0%s, for example, the manager held 13 positions. For each position, an average of 11.6 FDIC pools showed a better Treasury OAS. Those better FDIC pools offered $716 million of current balance. Adding zero-volatility spreads to the mix, for each manager position the FDIC list offered an average of 11.5 better pools with a total current balance of $715 million. But the biggest upgrade opportunity showed up in 30-year 2.5%s, where the manager held 32 positions. For each position held by the manager, the FDIC list offered an average of 55.6 pools with better OAS and a current balance across all better FDIC pools of $5.3 billion. That barely changes after adding zero-volatility to the mix. And in coupons through 4.5%, the opportunity to upgrade looks ample.

Exhibit 1: Analysis of an upgrade: money manager MBS compared to FDIC list

Note: All market levels as of 5/3/23 COB using BVAL pricing and Yield Book. The analysis selected all FDIC pools that matched the manager pool on maturity, coupon and vintage and then compared the manager pool only to the selected pools.
Source: BVAL, Yield Book, Santander US Capital Markets

To refine things further, pool vintage matters within coupon. Focusing on 30-year 2.5%s, the manager held most exposure in 2020 and 2021 vintages (Exhibit 2). The FDIC list showed ample opportunity to upgrade. For each 2020 pool, an average of 30.3 FDIC pools offered better OAS with a current balance of $1.9 billion. The opportunity narrowed only slightly after screening by zero-volatility spread, too. For each 2021 pool held by the manager, an average of 86.2 FDIC pools offered better OAS with a current balance across those pools of $9.1 billion. Again, a zero-volatility screen changed little.

Exhibit 2: Analysis of an upgrade by maturity, coupon and vintage

And finally, within vintage, the type of pool—generic or specified—matters. Since the analysis selected from the FDIC list pools that matched the manager’s position on maturity, coupon and vintage only, a specified pool on the FDIC list gets compared to all pools—generic or specified—on the FDIC list. Across the specified loan balance, geography and FICO pools held by the manager, the FDIC list showed between 49 and 107 FDIC pools with better OAS, with the better FDIC pools for each manager position offering between $4.8 billion and $11.9 billion in current balance (Exhibit 3).

Exhibit 3: Analysis of an upgrade by maturity, coupon, vintage and pool type

Note: All market levels as of 5/3/23 COB using BVAL pricing and Yield Book. The analysis selected all FDIC pools that matched the manager pool on maturity, coupon and vintage and then compared the manager pool only to the selected pools. As a result, a specified pool get compared to all FDIC pools, not just pools of the same type.
Source: BVAL, Yield Book, Santander US Capital Markets

On Friday, the FDIC’s agent, BlackRock, announced it would start taking reverse inquiry for pass-throughs still in the FDIC’s portfolio. The highlights:

Bidders need to submit indications of interest by 11:59p ET on Tuesday, May 9 using prices as of 4p ET on that day and including Treasury and TBA spot prices in a template distributed by BlackRock; the announcement says bidders need to “express competitive good faith interest in block sized portions of the agency MBS pool portfolio.”
BlackRock will use the indications of interest to put together a list of securities for a preliminary auction, focusing on areas where multiple bidders have expressed interest, and will release the list before 9:30a ET on Friday, May 12
Bidders for pools included in the preliminary auction need to submit bids on Monday, May 15 by 5p ET
BlackRock on May 15 by 10p ET plans to invite a limited number of bidders to a final auction based on the competitiveness of preliminary auction bids
A final auction will take place in the morning of Tuesday, May 16, the exact timing and details to be determined

This accelerates a process the FDIC began only three weeks ago and shortens the window for investors to identify target pools in the FDIC inventory and pools in their own portfolio that they should sell to create room. It is straightforward to analyze the value of the FDIC inventory relative to an investor’s own positions. The FDIC liquidation is not just an opportunity to cover short positions in different sectors or coupons or specified pool stories. It is an opportunity to upgrade a portfolio at a scale that may not come again.

* * *

The view in rates

The Fed clearly sees policy as tight, as Fed Chair Powell noted in his press conference after the May FOMC:

[W]e’ve raised [target rates] 500 basis points. I think that policy is tight. I think real rates are probably—you can calculate them many different ways—but one way is to look at the nominal rate and then subtract a reasonable estimate of, let’s say one year inflation, which might be 3%. So you’ve got 2% real rates. That’s meaningfully above what most people—what many people anyway—would assess as…the neutral rate. So policy is tight. And you see that in interest-sensitive activities. And you also begin to see it more and more in other activities. And if you put the credit tightening on top of that and the QT [quantitative tightening] that’s ongoing…we may not be far off, or possibly even at that level [of a sufficiently restrictive stance].

After the May FOMC, OIS forward rates now price steady fed funds through August and cuts of more than 50 bp into December. The market is clearly assigning significant weight to the possibility that tighter bank credit will magnify the impact of cumulative Fed hikes and drive cuts later this year.

The front end of the yield curve continues to show concern about a showdown over the US debt ceiling. Treasury Secretary Yellen’s recent notice that the federal government could run out of money by June 1 sparked a sharp rise in yields on Treasury bills maturing on or after that date. As of Friday morning, the bill maturing on May 30 trades at a mid-market yield of 4.42% while the bill maturing on June 1 trades at 5.11%

Fed RRP balances continue to climb and closed Friday near $2.23 trillion, below the level of recent weeks. Money market funds have seen some small net outflows in recent weeks, which may explain the lower RRP balances.

Settings on 3-month LIBOR have closed Friday at 533 bp, up 3 bp from a week ago. Setting on 3-month term SOFR closed Friday at 504 bp, down 4 bp from a week ago.

Further out the curve, the 2-year note traded Friday at 3.90%, down 27 bp over the last week. The 10-year note closed at 3.42%, unchanged over the last week.

The Treasury yield curve traded Friday morning with 2s10s at -46, flatter by 12 bp. The 5s30s traded Friday morning at 36 bp, 17 bp flatter on the week.

Breakeven 10-year inflation finished the week at 223 bp, up 2 bp in the last week. The 10-year real rate finished the week at 121 bp, unchanged in the last week.

The view in spreads

Volatility has moved up and stayed up since the collapse of SVB and the broadening of concerns about the ability of regional banks to hold onto deposits at a reasonable cost. High volatility has widened spreads on risk assets not only because of the uncertain economic and market impact of tighter credit but also because of resulting wider bid-ask spreads in markets. The Bloomberg investment grade cash corporate bond index OAS widened over the last week to 166 bp. The MBS has generally seen good auctions of the pass-throughs formerly held by Silicon Valley Bank and Signature Bank. Nominal par 30-year MBS spreads to the blend of 5- and 10-year Treasury yields traded Friday at 167 bp, roughly unchanged from a week ago. Par 30-year MBS TOAS closed Thursday at 62 bp, also roughly unchanged from a week ago.

Investors short volatility should note that the Treasury market has started to reflect concerns about a debt ceiling showdown beginning as early as June 1. Volatility should rise if the standoff goes down to the wire.

The view in credit

Most investment grade corporate and most consumer balance sheets look relatively well protected against the likely impact of Fed tightening. Fixed-rate funding largely blunts the impact of higher rates on both those corporate and consumer balance sheets, and healthy stocks of cash and liquid assets allow these balance sheets to absorb a moderate squeeze on income. But other parts of the market are funded with floating debt. Leveraged and middle market balance sheets are vulnerable, especially with the sharp tightening of bank credit in the wake of SVB. Commercial office real estate looks weak along with its mortgage debt. As for the consumer, subprime auto borrowers, among others, are starting to show some cracks with delinquencies rising quickly. Some commercial real estate funded with floating-rate mortgages have started to show some stress, too.

Steven Abrahams
steven.abrahams@santander.us
1 (646) 776-7864

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.

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