By the Numbers
Relative value of investor loans in private-label 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.
Investor loans have helped fuel issuance in private-label MBS this year even though they trade at a steep discount to investor loans placed in agency MBS. The substantial price discrepancy suggests that even after adjusting for relative illiquidity of private-label MBS the exposures may not be truly akin to one another. Larger loan balances securitized in private-label deals appear to account for some of the difference. But even after adjusting for this, certain private-label exposures appear to offer attractive relative value.
Stacking up exposures
Much has been made of the private-label market’s ability to price credit risk more efficiently than inelastic loan-level pricing matrices applied by the GSEs when purchasing a non-owner-occupied loan. The application of a consistent LLPA across a range of higher LTVs suggests that private-label issuance of agency eligible loans would be relegated to these corners of the LLPA grid. In reality, the collateral characteristics of investor loans securitized in the private-label market tend to closely mirror those pooled in agency MBS over the past five years (Exhibit 1).
Exhibit 1: Comparing collateral characteristics across investor execution channels
Source: Santander US Capital Markets, CoreLogic LP, Fannie Mae, Freddie Mac, eMBS
While the majority of collateral characteristics are substantially similar, one noticeable difference is that the average balance of investor loans that get pooled in PLS tend to be roughly $100,000 to $150,000 larger than those of agency specified pools. There are likely a couple reasons why larger loans tend to find their way into private-label trusts rather than agency execution. From a fundamental standpoint, smaller loans will generally require higher amounts of credit enhancement in private-label deals as loss severities generated via the liquidation of those loans will be higher than those of larger loans due to fixed costs associated with liquidation accounting for a larger percentage of a smaller loan. Additionally, from a practical standpoint, aggregators of investor loans likely favor loans with larger balances all else equal as it allows them to get to critical mass to issue a securitization faster, thereby minimizing both hedging and warehouse financing costs.
A look at the impact of loan balance in investor collateral
An analysis of investor loans’ sensitivity to nominal refinancing incentive across both agency and private-label channels shows some modestly skewed response to incentive across different loan balance cuts. Loans with balances between $100,000 to $200,000 show a modestly lower response to 100 bp of incentive in private-label channels as they have historically prepaid at 13 CPR versus 17 CPR in agency channels. However, when these loans are deep-in-the-money, they have prepaid 5 CPR faster in private-label deals than in agency pools. A more muted response to 100 bp of incentive in private-label channels is evident across larger loan balance as is a more magnified response to larger amounts of incentive (Exhibit 2).
Exhibit 2: Sizing up investor S-curves by channel and loan size
Source: Santander US Capital Markets, CoreLogic LP, Fannie Mae, Freddie Mac, eMBS – Note: reflects nominal (non-SATO adjusted) incentive
In theory, differences in response could be explained by the fact that risk-based pricing may not be equal across observations and that nominal incentive may not always equate to the same amount of risk-adjusted incentive. However, the average Spread at Origination (SATO) of loans in both agency and non-agency channels shows a maximum of 10 bp difference in weighted average SATO across vintages. Given this, risk-adjusted incentive should reasonably align with nominal incentive across observations.
Based on weighted average loan size across channels, bond holders in investor PLS will have greater exposure to loans with balances between $200,000 and $400,000, which have prepaid at 19 and 47 CPR given 100 bp and 200 bp of incentive respectively. Conversely, investors in agency specified pools will, depending on vintage, have more exposure to lower balance loans suggesting that investors in private-label trusts should demand some concession for owing more negatively convex investor collateral. However, that concession should converge when comparing current private-label exposures to low WALA specified pools as loan balances on both off these cohorts are generally in the range of 450k.
Valuing the agency-to-non-agency basis
Attempting to make a ‘like for like’ comparison between agency and non-agency investor exposures can be somewhat challenging. Definitionally, private-label pass throughs will be more negatively convex due to the structural leverage associated with the shifting interest structure which makes the senior bonds more levered to prepayments than agency pass throughs. Additionally, coupon options in private-label space will be stripped off the same collateral group while specified pools will carry different gross WACs given different pass-through rates.
One way to establish a level playing field for relative value analysis is to use an ‘equal OAS’ methodology as OAS will account for differences in structure and collateral. In this analysis, the 6.0% investor pass through at $1-16/32 behind the September TBA and an implied 2x coupon multiple is used to price the 6.5% pass through up one point form the 6.0%, consistent with the 6.0%-6.5% TBA coupon swap. This is likely a conservative assumption as investor collateral will be more positively convex than TBA and should garner a higher multiple. The 6.0% and 6.5% investor specified pools are priced at pay-ups of 20 and 26/32s respectively (Exhibit 3).
Exhibit 3: Valuing investor exposure using equal OAS
Source: Santander US Capital Markets, YieldBook
At current valuations, the spread between 6.0% PLS pass throughs and specified pools is $2-4/32s assuming a specified pool pay up of 20/32s for the pool and a $1-16/32 discount for the PLS pass through. An equal OAS framework calculates the differential to be roughly 16/32s given a theoretical pay- up for the pass-through of just over 4/32s, suggesting that private-label exposures are substantially cheap to agency pools.
Accounting for credit and liquidity
While the equal OAS methodology will account for differences in structure and convexity, it may not adequately account for potential credit risk in PLS and certainly does not account for the liquidity give up in PLS relative to specified pools. From a credit perspective, performance of both agency and non-agency collateral is relatively pristine. Modestly elevated delinquency rates in the 2018 private-label vintage can be largely attributable to a much smaller denominator of outstanding private-label loans in that vintage (Exhibit 4).
Exhibit 4: Credit performance of investor loans across agency and non-agency channels
Source: Santander US Capital Markets, CoreLogic LP, Fannie Mae, Freddie Mac, eMBS
Assuming no material concession for credit, it really comes down to liquidity which is historically difficult to value. In periods of relatively muted volatility, it appears that investors are being more than adequately compensated to sell the liquidity associated with agency pools, in periods of elevated volatility potentially less so.
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