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.

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

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