By the Numbers
Discount shopping in prime and non-QM MBS
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.
Prime and non-QM ‘AAA’ MBS trading well below par continue to attract non-agency investors. The draw is the potential return either from rising prepayments, the exercise of issuer call options or, in some cases, both. But important parts of the discount non-QM market look rich, particularly cohorts where the likelihood of issuer calls seems low. That skews relative value toward prime pass-throughs and prime front sequential cash flows, especially securities with larger concentrations of Florida loans.
Callability assumptions change in deep discount non-QM
Despite persistently slow actual prepayment speeds, pricing on non-QM bonds backed by lower gross WAC collateral continue to imply much faster speeds. Lower gross WAC non-QM bonds show very tight or even negative spreads to the curve if investors extrapolate from recent actual speeds. The apparently faster expected speeds likely come in part from the flattening of the yield curve since the start of this year, which has lowered forward mortgage rates and lifted the prepayment speeds projected by models. Investors also may be pulling forward anticipated interest rate cuts.
However, these revisions do not appear to fully account for the difference between empirical speeds and those implied by pricing to fair spreads. The gap is likely explained by investors assigning some probability that these deals get called despite the overwhelming majority of low WAC collateral trading well below the par call.
Using 2021 vintage non-QM deals as the best example of low gross WAC collateral and valuing the underlying collateral pools using current whole loan discount rates, the universe sits at a weighted average price of $88 with very few pools still trading at or near par. (Exhibit 1)
Exhibit 1: 2021 Vintage non-QM loans are currently a deep discount to par
Source: SanCap, Bloomberg LP
Admittedly, given the relatively long spread and rate duration of this cohort, there is substantial price upside to a drop in rates, a tightening in spreads or some combination. Additionally, investors may be weighing several factors that could increase the likelihood of deals being called. Hedging the duration of call rights, having the ability to purchase REO loans at fair market value and reducing the effective call strike by retaining discount bonds at issuance all potentially reduce the par call strike.
However, focusing on retained interests, the 2021 vintage is somewhat unique in that it is marked by a historically low cost of funds on liabilities which, in turn, generated large amounts of excess spread in these deals. Given the fact that risk retention is calculated based on market value, sponsors could satisfy risk retention in part or whole by simply retaining the excess spread cash flow. This is particularly impactful when thinking about issuers ability to call because they may not have retained enough subordinate principal and interest bonds to effect call economics, likely making these deals less callable than other vintages absent other factors.
Relative value skews in favor of prime pass throughs and sequentials
Unlike discount non-QM bonds, comparable prime and agency-eligible investor pass-throughs and sequential classes use a pricing convention of 6 CPR, more in-line with empirical speeds. All else equal, that assumption provides more upside to faster speeds than downside to slower ones.
To quantify this asymmetry, it helps to run a few cohorts of MBS across a variety of prepayment assumptions:
- ‘AAA’ non-QM bonds backed by less than 5% gross WAC collateral
- 2.5%-coupon prime pass-throughs
- 2.5%-coupon front sequential classes cut from the front 60% of the pass-through at issuance
Given the starting OAS on each bond in the respective cohort, the bond is then repriced to anywhere from 80% to 120% of the prepayment model at each bond’s base case OAS to establish potential price skew to faster or slower prepayments.
Low gross WAC non-QM ‘AAA’s have roughly the same price elasticity, assuming a 20% increase or decrease in prepayment assumptions with base case long term forecasted speeds of 7.5 CPR.
Both prime front sequential classes and pass-throughs exhibit a materially better profile than non-QM ‘AAA’s. For example, prices on prime pass throughs fall by just 0.83% assuming a 20% decrease in the model but 1.52% of upside to a 20% increase, effectively double the potential upside than downside (Exhibit 3).
Exhibit 2: Prime cashflows offer more skewed upside than non-QM ‘AAA’s
Source: SanCap, YieldBook
Taking a cue from the agency market on discount speeds
When analyzing prepayment S-curves, the majority of private-label collateral cohorts tend to exhibit similar absolute speeds when deeply out-of-the-money. Scanning collateral attributes such as loan balance, FICO, LTV and occupancy either show very limited differences in deep out-of-the-money speeds or are not adequately scalable in private-label exposures. Lower loan balance collateral in private-label trusts tends to exhibit a flatter S-curve and faster out-of-the-money speeds, however it is difficult to get large, direct exposure to lower loan balances, making it difficult to monetize.
One collateral story that is potentially scalable that can be gleaned from conventional execution is pools with larger concentrations of loans in Florida. Similar to conventional performance, deep-out-of-the money Florida loans in both prime and non-QM trusts exhibit faster speeds than other large states such as California, Texas, New York and New Jersey. In prime trusts, Florida loans with -150 bp of incentive on average prepay at 6 CPR with all other states ranging from 2 to 4 CPR. In non-QM trusts, Florida loans with -150 bp of incentive prepay on average at 10 CPR with other states prepaying anywhere from 5 to 8 CPR (Exhibit 3) Given this, investors may be able to generate better returns in pass-throughs and structure in prime cash flows with larger concentrations of Florida loans than in low gross WAC non-QM ‘AAA’s.
Exhibit 3: Deep out-of-the-money Florida loans prepay faster than others in prime and non-QM trusts
Source: Santander US Capital Markets, CoreLogic LP
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