MBS for investors worried about falling home prices

Brian Landy, CFA | September 29, 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.

Home prices have surprised a lot of people this year, rebounding to new highs this year after dipping in the second half of last year. However, some investors remain concerned that home prices could fall, perhaps if the economy were to enter a recession. Housing turnover could slow if home prices fall. But borrowers with a lot of accumulated equity are less sensitive to changes in home prices, whether higher or lower. Investors worried about home prices should look to seasoned pools with low LTVs, especially low loan balance pools. Investor pools also show little sensitivity to HPA, and likely at a lower pay-up than low loan balance.

Borrowers can respond very differently to changes in their loan-to-value ratio, and this depends on the loans’ current LTV (Exhibit 1). This graph provides a guide to discount prepayment stories—which pool types prepay faster overall, and which pool types are more sensitive to changes in home prices. The y-axis plots the average prepayment speed over the last 12 months for the 2.5% coupon of each pool type, separating faster from slower. The y-axis shows the sensitivity of prepayment speeds to changes in a loan’s current LTV, which is a good proxy for changes in home prices. The loan-to-value can decline for two reasons—it falls as the loan is paid down, and it falls when home prices increase. But amortization is small for loans early in their payment schedule, so home price changes are often the dominant factor. This calculation, however, does assume that loans with the same current LTV behave similarly regardless of other collateral differences like original LTV and seasoning.

Exhibit 1. There are big differences in home price sensitivity across pool types.

Years indicate non-specified “worst-to-deliver” pools of that vintage. INV is 100% investment properties. FICO is FICO<700.
Source: Fannie Mae, Freddie Mac, Santander US Capital Markets

The thick horizontal line represents the median prepayment speed, to help differentiate the fastest pools from the slowest. The fastest pools were LLB, followed by MLB and then HLB; all these pools have LTVs below 70%. The slowest pools were 2022 vintage pools with LTV over 70% and NY pools.

The thick vertical line separates pools with positive correlation to HPA on the right—more HPA (lower LTV) yields faster prepays. Many pool types fall near the line—these should have little sensitivity to home price changes.  A handful of seasoned cohorts fall slightly to the left of the line, which suggests speeds should fall as home prices increase. It is probably more realistic to think of those pool types as insensitive to home prices.

Investors worried about home price depreciation should focus on the pool types that sit near the vertical line. These should have more stable prepayments regardless of the future path of home prices. Many of these cohorts are low loan balance pool types with less than 70% LTVs. Several cohorts were more sensitive to LTV changes when the current LTV is greater than 70%, so those are plotted twice—purple for less than 70% LTV, and red for greater than 70% LTV. Many of those loan balance cohorts are among the most sensitive to home prices when the LTV is above 70%, so selecting pools with lower LTVs—whether from seasoning or significant past home price appreciation—is important. Other pool types with low HPA sensitivity include 100% investor pools, and low FICO pools that also have low LTVs.

Pools with a maximum loan size of $175k demonstrate how speeds vary with the loan-to-value ratio (Exhibit 2). These pools prepaid at slightly over 6 CPR last year when the LTV was less than roughly 70%. Note that below 20% LTV, which is not shown, prepayment speeds ramp up quickly. This analysis ignores them since there are few pools available with those LTVs.  Above 70% LTV, speeds fall quickly, to close to 2 CPR for loans approaching 100% LTV. The slopes of the red lines give the sensitivity of speeds to LTV, which is used in the first exhibit.

Exhibit 2. Discount prepayment speeds of Max $175k pools.

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

This data should help guide investors with a view on home prices—whether optimistic or pessimistic or somewhere in between—to specific pool types that provide an edge if that view comes true.