By the Numbers

Primary-secondary, FHA-VA, jumbo and other spreads in MBS

Brian Landy, CFA | September 22, 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.

As primary mortgage rates go, so goes MBS prepayment risk and negative convexity. Primary rates this year have diverged for conventional and FHA-VA, for jumbo loans and for borrowers with different credit scores. That has moved MBS risk around a bit—conventional and possibly jumbo risk arguably a little lower, FHA-VA a little higher. Borrowers with weaker credit scores may be marginally more negatively convex. And all of that comes into play for MBS trading around par.

Even though the coupon on a par-priced MBS generally rose through the spring and summer, the primary rate charged to borrowers did not increase as much (Exhibit 1). The primary-secondary spread usually increases when loan origination picks up during a refinance wave and falls when interest rates increase and refinancing subsides. However, early this year the spread remained wide despite low origination activity. Spreads were propped up by high volatility, which increases pipeline hedging costs for originators. But volatility fell in August and September, allowing the primary-secondary spread to collapse as originators attempt to drum up more business.

Exhibit 1. The primary-secondary spread recently touched 100 bp.

Source: Optimal Blue, LLC., Yield Book, Santander US Capital Markets

The primary rate data comes from data on mortgage rate locks published daily by Optimal Blue. Separate indices are published for conventional 30-year loans, FHA loans, VA loans, and jumbo loans. The jumbo category is broader than the name implies, capturing any non-agency-eligible rate locks. The conventional data Is also available as separate series for borrowers with different credit scores and borrowers with high and low loan-to-value ratios.

Mortgage rates did not move the same way for all mortgage products (Exhibit 2). The rate paid by FHA and VA borrowers fell relative to conventional rates, and the spreads for both are near the 5-year lows. The FHA rate ranged from 20 bp to 30 bp higher than the conventional rate from 2018 through 2022, but now is about 10 bp lower than the conventional rate. The FHA also lowered mortgage insurance premiums this year, making the FHA product the least expensive it has been in over five years compared to conventional loans.

Exhibit 2. FHA rates dropped below conventional rates, while jumbo rates jumped sharply relative to conventional.

Source: Optimal Blue, LLC., Yield Book, Santander US Capital Markets

The jumbo rate has widened relative to the conventional rate for most of the year. In 2022, the average jumbo rate at times was almost 40 bp below conventional. But recently it has been over 30 bp wider. This likely reflects that the composition of the jumbo index is changing as fewer borrowers with large mortgages move. That means the index is more heavily represented by non-qualified mortgages that generally are required to pay a higher mortgage rate.

Borrowers with lower credit scores typically pay a higher mortgage rate (Exhibit 5). However, those spreads have narrowed considerably over the past few months. Fannie Mae and Freddie Mac lowered upfront credit fees earlier this year, but not by enough to account for this large shift. There is little spread difference between borrowers with credit scores below 740, and only a roughly 10 bp spread over borrowers with credit scores 740 or higher. This suggests that originators are widening the credit box to generate business.

Exhibit 3. The premium charged for low credit score borrowers has fallen.

Source: Optimal Blue, LLC., Yield Book, Santander US Capital Markets

Mortgage rates are high enough that almost no borrowers in conventional pools are in-the-money to refinance (Exhibit 4). This shows that at a current mortgage rate the average expected prepayment speed is around 6 CPR, based on historical norms. Of course, interest rates are much higher than typical, and more people than normal moved following the pandemic, so housing turnover is currently a bit below the typical level shown in the chart. It would take a tremendous drop in rates to cause an appreciable pickup in refinancing and prepayments. A 300 bp drop would only push 18% of borrowers in-the-money to refinance and lift the average speed to 12 CPR from 6 CPR.

Exhibit 4. Almost no GSE borrowers are in-the-money to refinance.

As of 9/20/2023. Source: Fannie Mae, Freddie Mac, Santander US Capital Markets

But newer vintages are more exposed to lower rates (Exhibit 5). For example, almost none of the currently outstanding 2023 vintage pools are in-the-money to refinance. But a 75 bp rally would push roughly 10% of the vintage into refinanceable territory. An additional 100 bp would increase that number to 63.3% and make 11.7% of the 2022 vintage refinanceable. But the bulk of outstanding are in 2020 and 2021 vintage pools and need mortgage rates to drop almost 500 bp to become refinanaceable.

Exhibit 5. Even 2023 production is well out-of-the-money to refinance.

Source: Fannie Mae, Freddie Mac, Santander US Capital Markets

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.