By the Numbers
What to expect from prime MBS prepayments in a rally
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.
Investors in prime private-label MBS are reaching for discount cash flows in preparation for rising prepayments. Prepayment rates on jumbo and investor cash flows through the last refinancing cycle were driven by a combination of credit availability, policy and demand for both jumbo and investor loans. The outlook for all these drivers of prepayments may look markedly different into the next refinancing cycle and should have disparate impacts on the ultimate magnitude of prepayments in prime MBS. Both pass-throughs and structure backed by agency-eligible investor loans should offer better convexity.
Prime prepayments – now versus then
Level setting the landscape for prepayments first requires looking at the differences in prepayments today versus the last refinancing cycle between 2020 and 2022 as they are material. The Covid era refinancing wave was marked by a substantial draw down in credit availability which, in turn, created friction to refinancing jumbo mortgage loans. Jumbo mortgage credit availability, despite strong housing fundamentals, is somewhat looser than it was during the Covid tights but tighter than observations prior to a wave of bank failures in the first quarter of last year, fueled to some degree by the extension of highly negatively convex jumbo mortgage loans into the Fed’s tightening cycle (Exhibit 1).
Exhibit 1: Credit availability for jumbo mortgages remains relatively tight
Source: Mortgage Banker’s Association, Santander US Capital Markets
As a result of pandemic-related credit tightening, the paradigm that higher loan balance loans should show an elevated response to the same amount of incentive as lower balance ones did not hold. Conforming jumbo loans that could be sold to Fannie Mae or Freddie Mac prepaid substantially faster than non-conforming ones. Looking at that relationship today in a more normalized credit market, conforming and non-conforming jumbo loans prepay at the same rate and nominally faster than those cohorts did during the 2020-2022 observation period (Exhibit 2). Faster speeds in the 2022-current observation period are likely a function of two factors. First, substantial capacity to refinance loans currently likely creates a more acute response to incentive. Secondly, limited observations of loans with substantial incentive to refinance drive more concentrated and potentially faster observations.
Exhibit 2: Jumbo conforming and non-conforming loans prepay at the same speed
Note: Observations are fixed-rate loans only. The 2020-22 observation period is 2/20 to 6/22. The 2022-2024 observation period is 7/22 to 7/24. Refinancing incentive is adjusted for risk-based pricing (SATO) at origination.
Source: Santander US Capital Markets, CoreLogic LP.
Looking forward, policy may impact the relationship between conforming and non-conforming jumbo loans. In the event of a Republican victory in November, President Trump could, and likely would, replace current Federal Housing Finance Agency Director Sandra Thompson. While it’s far to early to speculate who might replace Director Thompson, the mandate would likely be to shrink the GSE’s lending footprint, consistent with policies enacted by former Director Mark Calabria.
Absent an explicit reduction in the GSE jumbo conforming limit, the enterprises’ pricing grids could be used to push more high balance loans to private execution. The implementation of an Adverse Market Delivery Charge could force more of these loans to private-label or balance sheet channels. However, based on current market conditions, there should be little friction to refinancing these loans in private-label execution.
Negative convexity in jumbos likely to remain elevated
The reduction in bank demand for negatively convex assets in the wake of Silicon Valley Bank and other notable bank failures has not materialized in wider risk-based pricing for non-conforming jumbo loans. Jumbo survey rates currently sit just 7 bp above conforming rates and the lack of broad-based balance sheet demand from depositories has done little to hinder refinancing of non-conforming jumbo (Exhibit 3). With that said, the stickiness of jumbo rates to conforming ones is in no small part a function of relatively tight spreads in private label pass through and structured execution as well as a relatively low cost of credit. If spreads, particularly pass through spreads, were to widen materially, that would impede securitization conduits’ ability to keep a lid on jumbo rates and the spread between jumbo and conforming rates would widen accordingly.
In fact, the lack of bank demand for non-conforming jumbo loans may make the asset more negatively convex as the channels these loans are originated through shift from depository retail channels to correspondent and broker channels that face securitization conduits. Historically, loans originated through broker networks tend to prepay faster than those originated through other channels after for controlling for key drivers of prepayments including incentive and loan size.
Exhibit 3: Non-conforming rates remain tight to conforming despite weak bank demand
Source: BankRate, Santander US Capital Markets
Investor loans continue to provide prepay protection
Given the prospects for elevated negative convexity in jumbo loans, both pass-throughs and structure backed by agency-eligible investor loans should offer better convexity. At an absolute minimum, average loan sizes on deals backed by agency investor loans are roughly half of those found in jumbo deals which, in and of itself, should provide substantial relative prepayment protection. Historically, investor loans have shown not only slower absolute speeds given the same amount of refinancing incentive as owner-occupied ones, they also exhibit a substantially more muted response to small amounts of refinancing incentive (Exhibit 4). Observed prepayments on agency-eligible investor loans in private MBS trusts between 2020 and 2022 showed almost no response to 25 bp of refinancing incentive and were roughly 10 CPR slower than owner-occupied loans given 100 bp of refinancing incentive.
Exhibit 4: Investor loans in PLS trusts exhibit flatter S-curves
Source: Santander US Capital Markets, Core Logic LP Observations are fixed-rate loans only. 2020-22 observation period is 2/20 to 6/22. Refinancing incentive is adjusted for risk-based pricing (SATO) at origination.
Prospective policy changes may drive the amount and profile of agency-eligible investor loans that ultimately wind up in private label deals. Directionally, a Republican win in November likely paves the way for a smaller GSE footprint and investor loans along with high balance loans may be an area of focus for the next FHFA director. However, new leadership would likely take valuable lessons from prior experiences, as the caps on investor loan deliveries implemented under former Director Calabria were highly disruptive. Once again, FHFA may use the pricing grid to trim purchases from their footprint. A bump in LLPAs, particularly at the lower end of the LLPA grid would likely create substantial competition for the Enterprises from both securitization conduits and potentially life company portfolios who have, in recent years, been adding higher WAC, higher SATO whole loan exposures. A material pull back in purchases of investor loans by the GSEs should translate to a meaningful, more positively convex investment exposure to these loans at a substantial discount to where that exposure currently trades in the specified pool market.
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