By the Numbers

Specified pool value across the coupon stack

| July 28, 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.

MBS investors tend to undervalue the advantage of loan balance or a Texas address in today’s lower coupons. They then tend to undervalue Florida loans and FICO in higher coupons. Accounts managing for total returns should find good value in matching the right spec to the right coupon.

Mispricing of loan balance across coupons

Pools with maximum loan sizes no more than $175,000 are currently trading at wide OASs to TBA in low coupons, but much of the advantage fades in high coupons (Exhibit 1). Each point on the chart represents a cohort of 30-year fixed rate loans of a specific coupon, vintage, and loan balance pool type. These cohorts are all included in the Bloomberg MBS index. The OAS difference is plotted against the weighted average coupon of the loans in that cohort. At the lowest WACs the low loan balance cohorts are current roughly 30 bp to 40 bp wider than the corresponding TBA. But at the highest coupons, the difference has dropped to nearly zero in some cohorts.

Exhibit 1. Low loan balance pools are trading at wide OASs in low coupons.

Source: Bloomberg, Santander US Capital Markets

Low loan balance pools typically refinance slower than TBA when interest rates are low but prepay faster than TBA from housing turnover when interest rates are high. In fact, in lower coupons the loan balance pools so far this year have been paying faster than non-spec pools for the same vintage and faster than TBA. The wide option-adjusted spreads suggest that the market is undervaluing the extension protection from these pools.

Pools with maximum loan sizes of $200,000 and $225,000 also widen at low coupons (Exhibit 2). However, the degree of widening is lower. Most cohorts trade less than 20 bp wider than TBA, compared to up to 40 bp wider in the lower balance cohorts. The gap narrows further in high coupons and is comparable to the lower balance cohorts.

Exhibit 2. Max $200,000 and Max $225,000 pools also have wide OASs in low coupons.

Source: Bloomberg, Santander US Capital Markets

The low coupon advantage almost vanishes for pools with maximum loan sizes of $250,000 and $275,000 (Exhibit 3). These pools typically trade between 5 bp and 15 bp wider than TBA pools, so there is a spread advantage, but it hardly varies across coupons. There is not a clear value winner in any coupon in these pool types.

Exhibit 3. Max $250,000 and $275,000 pools do not widen at low coupons.

Source: Bloomberg, Santander US Capital Markets

Valuation across LTV

Pools with high LTVs have a small option-adjusted spread advantage in lower coupons, but it drops close to zero in high coupons (Exhibit 4). These pools usually turnover faster than TBA, which would benefit low coupons, but investors may be concerned that borrowers have such strong lock-in that the speed advantage won’t materialize. Speeds in LTV pools this year have come in faster than non-spec pools of the same vintage and faster than TBA. But the small OAS advantage suggests a lot of the speed advantage is priced in. The high coupons are dominated by relatively young loans that did not benefit from the historic home price appreciation from 2020 into mid-2022. Some of these borrowers may even be locked out of a refinance if their home values dropped. There has been a lot of interest in those pools this year, and production has been higher in 2023 than 2022, but the demand for these pools appears to be keeping spreads in-line.

Exhibit 4. Option-adjusted spread difference for high LTV pools.

Source: Bloomberg, Santander US Capital Markets

Flat valuations across investor properties

Pools backed by loans for investment properties and second homes are trading at similar option-adjusted spreads as TBA pools across the coupon stack (Exhibit 5). Most cohorts are less than 10 bp wider than TBA and many trade at the same or tighter OAS, so none of the coupons stand out as providing a lot of value in this pool type.

Exhibit 5. Option-adjusted spread difference for Investor and 2nd Home pools.

Source: Bloomberg, Santander US Capital Markets

Wider than a 10-gallon hat

Pools backed by loans from Texas are also trading at wide option-adjusted spreads in low coupons (Exhibit 6). Texas has had a robust housing market and experienced in-migration of people, which tends to push housing activity higher. Investors may be undervaluing the possibility that discount Texas pools will post faster speeds than other pool types. So far this year, Texas pools tend to pay faster than non-spec pools of the same vintage and faster than TBA. These pools are available at relatively low pay-ups, which lowers the risk of owning these pools for some investors.

Exhibit 6. Option-adjusted spread difference for 100% Texas pools.

Source: Bloomberg, Santander US Capital Markets

Valuations across FICO

Pools of borrowers with low credit scores, however, trade at wider option-adjusted spreads in higher coupons (Exhibit 6). These borrowers typically turnover faster as credit curing allows them to access cheaper financing and they often need a larger home. In a weak economy, the prospect of faster default rates also can contribute to extension protection in these pools. However, these borrowers tend to be less likely to take advantage of refinance opportunities, which provides some prepayment protection in higher coupons. The market appears to value the extension protection more than the refinance protection in these pools.

Exhibit 7. Option-adjusted spread difference for low FICO pools.

Source: Bloomberg, Santander US Capital Markets

Valuations across Florida and New York

Pools of entirely Florida loans widen significantly at higher coupons (Exhibit 8). Florida loans benefit from a strong housing market and heavy home price appreciation, which should boost turnover speeds on lower coupon pools. However, the borrowers face high mortgage taxes, which can slow refinance speeds and provide prepayment protection. The spreads suggest that these pools are also a cheap source of prepay protection in higher coupon pools.

Exhibit 8. Option-adjusted spread difference 100% Florida pools.

Source: Bloomberg, Santander US Capital Markets

Pools backed by New York loans also trade at a wider spread to TBA in higher coupons, but the advantage is smaller than for Florida and low FICO pools (Exhibit 9). New York borrowers pay higher mortgage taxes than Florida borrowers, which provide prepayment protection, but a tepid housing market prevents these pools from providing extension protection. This prepayment behavior is better known than Florida pools, which may account for the tighter OASs in high coupons. And in low coupons, many cohorts are trading at tighter OASs than TBA, suggesting investors think these pools will prepay faster than Bloomberg’s prepayment model expects.

Exhibit 9. Option-adjusted spreads across coupons for New York.

Source: Bloomberg, Santander US Capital Markets

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

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