By the Numbers
Better convexity, better value in 100% FHA pools
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.
Pools of loans insured by the Federal Housing Administration typically have more stable cash flows and better convexity than those guaranteed by the Veterans Administration, and investors are taking note. Monthly production of FHA-only pools recently approached $4 billion, a new record. And upwards of 10% of total Ginnie Mae issuance is making its way into these pools each month. These FHA-only pools have a refinance response close to that of max $250,000 pools in either Ginnie Mae or UMBS. And investors have been able to buy these FHA-only cash flows at a fraction of the pay-up for comparable loan balance pools. Based on cash flow, the sector looks like compelling relative value.
A comparison of price premiums for comparable convexity
Pools backed entirely by FHA loans already trade at a modest price premium to the Ginnie Mae TBA market. New 30-year Ginnie Mae 6.0% custom pools backed entirely by FHA loans, for example, trade at a pay-up of 15/32s to TBA (Exhibit 1). At the same time, new Ginnie Mae 6.0% custom pools backed by loans with maximum $250,000 balance trade at a higher premium of 30/32s over TBA. And new UMBS 6.0% specified pools backed by loans with a maximum $250,000 balance trade 24/32s over the UMBS TBA and 21.5/32s over the Ginnie Mae TBA. Under the assumption that the FHA-only pool has comparable convexity, it looks undervalued relative to its Ginnie Mae and UMBS alternatives.
Exhibit 1: Pay-ups for 100% FHA pools are lower than for Max $250k pools.
Pay-ups are indicative, not firm offers. Pay-ups vary with other pool attributes, like servicer.
Source: Yield Book, Santander US Capital Markets.
New attention and more volume in FHA-only pools
Attention to pools backed entirely by FHA loans has picked up since mortgage rates dropped at the end of 2023 and certain VA loans prepaid quickly, catching the market by surprise. This highlighted the comparatively better prepayment behavior of FHA loans, so demand increased for pools backed solely by FHA loans (Exhibit 2). Originators have created FHA-only pools since at least January 2018, and recent monthly volume has blown past the prior two peaks in 2019 and 2020. As a percentage of total Ginnie Mae pool issuance, FHA-only pools recently accounted for 12% of issuance, compared to the prior peak of about 4% to 5% set in late 2020.
Exhibit 2: Issuance of 100% FHA pools has jumped in recent months.
FHA-only excludes pools that meet other specified pooling criteria.
Source: Ginnie Mae, Santander US Capital Markets.
The S-curves of FHA-only pools
Investors are paying up for FHA loans since their S-curves are flatter than that of VA loans that make up a large portion of the TBA-deliverable Ginnie Mae multi-issuer pools (Exhibit 3). The typical VA loan that is too large to qualify for current low loan balance specified pools—over $300,000 original loan size—peaked around 70 CPR when 150 bp in-the-money. But FHA loans over that same limit peaked under 50 CPR. That is comparable to the speeds of conventional loans with loan sizes between $225,000 and $250,000, a specified pooling category that has gained popularity over the last few years. It is also comparable to speeds of FHA and VA loans that fall within those same loan size thresholds.
Exhibit 3: Generic FHA S-curves are comparable to conventional Max $250k collateral.
Performance from January 2014 to May 2024, 30-year fixed-rate, 6 to 36 WALA. FHA and VA speeds are voluntary prepayments only, as reported in the loan-level disclosures. UMBS speeds are total CPR from loan-level disclosures. Rate incentive calculated comparing a loan’s note rate to the average note rate of loans originated, calculated separately for FHA, VA, and UMBS.
Source: Fannie Mae, Freddie Mac, Ginnie Mae, Santander US Capital Markets.
The FHA and VA S-curves also exhibit an elbow shift relative to the conventional S-curves—speeds start ramping while loans are still out-of-the-money. Each loan’s rate incentive is calculated compared to the origination rate for those loans—FHA loans to the FHA rate, VA loans to the VA rate, conventional loans to the conventional rate. The FHA rate incentive is also adjusted for differences in annual mortgage insurance premiums on the current and prospective loan. The remaining elbow shift likely reflects the propensity for these borrowers to do cash-out refinances and move, even if the new loan’s rate is higher. FHA borrowers especially may have stronger lock-in—loans marginally out-of-the-money may cash-out and move, while loans deep out-of-the-money are more likely to keep borrowers in their homes. The elbow shift could lift the value of modestly discount FHA pools and lower the value of modestly premium FHA pools.
It is important to note that these S-curves exclude prepayments from buyouts, which at times have been high for FHA loans. But S-curves that include buyouts are heavily influenced by the time frame selected—buyouts were low from 2014 through 2019, and after 2021. But buyouts were high during 2021 and 2022. It is clearer to show S-curves without buyouts and separately consider the risk of buyouts, which is influenced by the pace of new loan delinquencies. During the Covid-19 pandemic, FHA speeds were at times 10 CPR faster due to buyouts.
Other considerations in FHA-only pools
The interest in FHA-only pools—or no-VA pools, since including rural housing and Indian housing loans should be acceptable—has waxed and waned over the last few years since the story first gained traction in 2019. That has helped keep pay-ups below those for the loan size buckets with comparable S-curves. Pay-ups could increase over time as more FHA loans are pooled separately, since this will increase the concentration of VA loans in multi-issuer pools and degrade the quality of the G2SF TBA.
Investors that can dollar roll also need to consider special financing, when available. Many higher coupon Ginnie Mae rolls are currently special, which may lower the attractiveness of 100% FHA pools. And custom pools are not TBA-deliverable, which lowers liquidity and in theory those pools could trade at a lower price than the corresponding TBA. However, the surge in production demonstrates that many investors are buying these pools despite roll specialness. And some investors prefer to invest in CMOs, which don’t benefit from special rolls or the liquidity of TBA-deliverable pools.
On the other hand, Ginnie Mae MBS have special appeal to certain investors. Banks are generally reducing mortgage holdings, but any replacement buying is typically done in Ginnie Mae MBS and not conventional to benefit from the advantageous treatment under risk-weighted capital rules. Foreign investors are drawn to the full-faith-and-credit guarantee attached to Ginnie Mae MBS; it makes Ginnies a closer alternative to investing in US Treasuries compared to Fannie Mae and Freddie Mac MBS.
There are some other risks associated with FHA loans. These borrowers tend to have weaker credit profiles, so are more likely to default. And this report shows that the pace of new delinquencies has been trending higher since 2022. So the risk of buyouts could be rising. And an industry group is asking the FHA to allow borrowers to finance closing costs from refinancing in the loan balance. They think this will allow more borrowers to refinance. However, during the pandemic rates were low enough that most borrowers should have refinanced despite the inability to include closing costs in the loan balance. So, it is unclear that this proposal, if the FHA were to implement it or something like it, would have an appreciable effect on FHA speeds.
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