By the Numbers

Financing MBS through structural leverage and other means

Chris Helwig | October 18, 2024

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.

Agency MBS investors have a unique set of choices when it comes to financing their positions. There is traditional financing or the dollar roll market, and then there is leverage through CMO structuring. Portfolios either limited in their use of traditional financing or looking to mitigate the associated mark-to-market risk can create levered exposure by owning inverse IO. Of course, portfolios with access to either financial or structural leverage can weigh the relative value of both. At current levels, dollar rolling still wins, but inverse IO can look attractive against a traditional repo-funded position.

Getting leverage through an inverse IO

CMO structuring creates an inverse interest-only bond, or inverse IO (IIO), by splitting a fixed-rate pass-through or CMO into two components:

A floating-rate principal and interest bond, and
An IIO that gets any interest leftover after paying the floating-rate coupon.

The floater typically gets all the par principal and gets interest up to a cap, which ensures enough cash flow from the fixed-rate collateral to pay the floating-rate coupon. Without a cap, the floating coupon could rise to a level where it exceeded the interest available from the fixed-rate bond. As a result, the IIO is equivalent to a position in the fixed-rate collateral with maximum structural leverage or financing through the sale of the floater. The IIO coupon consequently is floored at zero, when the floater is getting all the interest, and reaches its maximum when the floater is getting its lowest coupon. That maximum equals the floating-rate cap less the stated margin on the floater, commonly referred to as the ‘strike.’

A simplified example of this would be a two-tranche CMO deal where the cap is struck at the pass-through rate on the underlying collateral. GNR 2024-144 is an example. The deal is backed by G2SF 6.5% collateral including pools like G2 DC6776. The trust then issued a $100 million 6.5% cap S+115 floater (FA) and a $100 million notional 5.35% strike IIO (SA). The two cash flows’ coupons will move inversely to each other as the benchmark rate rises or falls (Exhibit 1).

Exhibit 1: GNR 2024-144 floater (FA) and IIO (SA) coupons across benchmark rates

Source: Santander US Capital Markets

Getting leverage through financing

MBS investors can also get leverage through financing. Financial leverage by and large is generated by buying MBS positions for cash and then pledging those positions in the repurchase market. The investor would put up some amount of equity commonly referred to as a ‘haircut’ and receives debt financing for the remaining market value of the position. Repo financing for MBS pools is floating-rate and short-term in nature, generally trading with maturities ranging from overnight to 1- to 3-month tenors. Specified pools like G2 DC6776 will generally require 3% to 5% of market value equity to be financed in the repo market.

In both IIO and repo, the bond holder is effectively ‘short’ a floating-rate cost of funds. The IIO coupon is the cap less the benchmark index rate and the additional margin paid on the floater. The coupon in repo is the coupon of the asset less the floating repo rate. As a result, both IIO and a levered position in MBS will generate more carry as the benchmark rate declines and less as it rises.

One key difference between financing with a repurchase agreement and being long IIO is that the floating-rate liability in the IIO cannot rise above the cap rate on the floater while repo financing is uncapped. The repo cost of funds could exceed the interest received on the financed asset. Additionally, the funding spread achieved by the sale of the floater cannot vary, while repo spreads can vary each time the financing is renewed. Finally, the IIO position is financed to maturity while repo can be renewed, or not.

One other important difference is that repo financing for securities is by and large a mark-to-market arrangement, meaning the investor will be required to post not only the initial equity haircut but make any additional payments to maintain that haircut. Should the value of the securities decline, the investor would have to make margin payments to maintain the initial haircut. If the value of the securities increase, then any additional market value equity is paid to the investor. This is fundamentally very different than structural leverage in inverse IO which is akin to term non-mark-to-market funding.

Comparing IIO and financed positions

IIO can be compared to either a funded or unfunded levered MBS position where a funded position would involve using MBS as collateral for a repurchase transaction and an unfunded position would be expressed in the TBA dollar roll market. Exposures can and should be evaluated given both the amount and cost of leverage available in each form of financing. The funding spread over the benchmark rate in each form of financing is determined somewhat differently. In the case of a traditional repo, it is simply the nominal spread charged by the lender also known as the repo buyer. In the dollar roll market, the spread is determined using both the price differential between the purchase and sale legs of the roll and the intra-month prepayment assumption to determine any ‘specialness’ in the financing rate. The implied funding spread in an IIO is the OAS on the floater sold to finance the position since OAS accounts for the cost of the embedded cap (Exhibit 2).

Exhibit 2: Funding cost and leverage across exposures

Source: Santander US Capital Markets, YieldBook

To calculate the funding margin and leverage implied by the IIO execution, the 5.35% strike IIO is run at a price of 3-28/32. The corresponding 6.5% cap S + 115 bp floater is run at a price of 100-6/32. The market value of the floater is then divided by the market value of the IIO which is equivalent to the ‘haircut’ in a repurchase transaction (Exhibit 3).

Exhibit 3: Calculating funding spreads and leverage in IIO

Source: Santander US Capital Markets, YieldBook

The floater has an OAS of 60 bp and a market value of just over $100 million. Dividing that market value by that of the IIO gives us implied leverage of nearly 26 turns. Based on indicative levels, pools comparable to those backing the IIO would finance at a margin of 30 bp and a haircut of 3.0% to 5.0%. Using the mid-point of the indicative haircuts implies 25 turns of leverage available in the repo market.

Finally, we compare dollar roll financing to the other two exposures. Using a long-term projected speed of 37 CPR and a price drop of 2.125/32s for the G2SF 6.5% dollar roll implies ‘special’ financing of approximately 60 bp versus spot SOFR, an implied monthly financing spread of -5 bp. Assuming the need to post 3.5% margin for the TBA transaction translates to just over 28 turns of leverage, making dollar rolling currently the most efficient form of financing from both a leverage and cost-of-funds perspective.

There are additional considerations when comparing funding costs, particularly the presence of a cap on the funding in the floater and IIO structure. In the GNR 2024-144 structure, the floater buyer is short a 6.5% cap, effectively making the inverse long a cost-of-funds cap. The higher cost-of-funds implied by the OAS on the IIO is, in part, a function of the bond holder being long a cap while the repo seller is not. Assuming a 1-month spread of 30 bp on repo financing and an OAS of 60 bp on the floater implies that the premium captured for selling the cap is 30 bp. By comparison, a 4.5-year, monthly pay, bullet cap struck at 6.5%, consistent with the weighted average life of the floater, yields a premium of 37 bp, roughly in-line with the difference between the floater OAS and the repo spread. Differences between the two are largely a function of the fact that the balance on the floater declines over time while the notional on the derivative remains constant to maturity.

But wait, there’s more

While the dollar roll market currently offers the most attractive financing terms, there are certainly other factors that will weigh on investors’ decision to use structural or financial leverage. Financing rates in the roll market are ultimately driven by both prepayment assumptions and the price drop. A rally in mortgage rates would drive prepayment assumptions higher and the price drop could compress, either of which would change the implied financing rate. Given this, investors who dollar roll are constantly subject to changes in assumptions.

Repurchase transactions generally need to be rolled every month, at which point investors may be subject to different terms based on market conditions. In the most dire of circumstances, when markets are dislocated or credit is contracting, the uncommitted nature of traditional repo financing means that investors may not be able to roll their repo at any level. Given this, the combination of committed, term financing offered through a position in IIO should trade at a premium to other forms of leverage.

In a simplified case, investors should prefer financial leverage when the financing spread on repo is less than the OAS on the floater, all else equal. However, as illustrated above, all else is not equal given the fact that term non-mark-to-market financing should always trade at a premium to 1-month, uncommitted financing. The value of non-mark-to-market financing should increase with market volatility, but it is difficult to attach a specific value to that. In the case where volatility is low and floater spreads are wide, investors will likely elect financial rather than structural leverage.

Additionally, only certain MBS investors can use financial leverage, mainly REITs and hedge funds. Some of the largest MBS investors, particularly mutual funds, generally carry covenants that substantially limit the use of financial leverage. Given this, large asset managers will likely look at the value proposition between dollar rolling positions versus taking structural leverage.

Chris Helwig
christopher.helwig@santander.us
1 (646) 776-7872

This material is intended only for institutional investors and does not carry all of the independence and disclosure standards of retail debt research reports. In the preparation of this material, the author may have consulted or otherwise discussed the matters referenced herein with one or more of SCM’s trading desks, any of which may have accumulated or otherwise taken a position, long or short, in any of the financial instruments discussed in or related to this material. Further, SCM may act as a market maker or principal dealer and may have proprietary interests that differ or conflict with the recipient hereof, in connection with any financial instrument discussed in or related to this material.

This message, including any attachments or links contained herein, is subject to important disclaimers, conditions, and disclosures regarding Electronic Communications, which you can find at https://portfolio-strategy.apsec.com/sancap-disclaimers-and-disclosures.

Important Disclaimers

Copyright © 2025 Santander US Capital Markets LLC and its affiliates (“SCM”). All rights reserved. SCM is a member of FINRA and SIPC. This material is intended for limited distribution to institutions only and is not publicly available. Any unauthorized use or disclosure is prohibited.

In making this material available, SCM (i) is not providing any advice to the recipient, including, without limitation, any advice as to investment, legal, accounting, tax and financial matters, (ii) is not acting as an advisor or fiduciary in respect of the recipient, (iii) is not making any predictions or projections and (iv) intends that any recipient to which SCM has provided this material is an “institutional investor” (as defined under applicable law and regulation, including FINRA Rule 4512 and that this material will not be disseminated, in whole or part, to any third party by the recipient.

The author of this material is an economist, desk strategist or trader. In the preparation of this material, the author may have consulted or otherwise discussed the matters referenced herein with one or more of SCM’s trading desks, any of which may have accumulated or otherwise taken a position, long or short, in any of the financial instruments discussed in or related to this material. Further, SCM or any of its affiliates may act as a market maker or principal dealer and may have proprietary interests that differ or conflict with the recipient hereof, in connection with any financial instrument discussed in or related to this material.

This material (i) has been prepared for information purposes only and does not constitute a solicitation or an offer to buy or sell any securities, related investments or other financial instruments, (ii) is neither research, a “research report” as commonly understood under the securities laws and regulations promulgated thereunder nor the product of a research department, (iii) or parts thereof may have been obtained from various sources, the reliability of which has not been verified and cannot be guaranteed by SCM, (iv) should not be reproduced or disclosed to any other person, without SCM’s prior consent and (v) is not intended for distribution in any jurisdiction in which its distribution would be prohibited.

In connection with this material, SCM (i) makes no representation or warranties as to the appropriateness or reliance for use in any transaction or as to the permissibility or legality of any financial instrument in any jurisdiction, (ii) believes the information in this material to be reliable, has not independently verified such information and makes no representation, express or implied, with regard to the accuracy or completeness of such information, (iii) accepts no responsibility or liability as to any reliance placed, or investment decision made, on the basis of such information by the recipient and (iv) does not undertake, and disclaims any duty to undertake, to update or to revise the information contained in this material.

Unless otherwise stated, the views, opinions, forecasts, valuations, or estimates contained in this material are those solely of the author, as of the date of publication of this material, and are subject to change without notice. The recipient of this material should make an independent evaluation of this information and make such other investigations as the recipient considers necessary (including obtaining independent financial advice), before transacting in any financial market or instrument discussed in or related to this material.

Important disclaimers for clients in the EU and UK

This publication has been prepared by Trading Desk Strategists within the Sales and Trading functions of Santander US Capital Markets LLC (“SanCap”), the US registered broker-dealer of Santander Corporate & Investment Banking. This communication is distributed in the EEA by Banco Santander S.A., a credit institution registered in Spain and authorised and regulated by the Bank of Spain and the CNMV. Any EEA recipient of this communication that would like to affect any transaction in any security or issuer discussed herein should do so with Banco Santander S.A. or any of its affiliates (together “Santander”). This communication has been distributed in the UK by Banco Santander, S.A.’s London branch, authorised by the Bank of Spain and subject to regulatory oversight on certain matters by the Financial Conduct Authority (FCA) and the Prudential Regulation Authority (PRA).

The publication is intended for exclusive use for Professional Clients and Eligible Counterparties as defined by MiFID II and is not intended for use by retail customers or for any persons or entities in any jurisdictions or country where such distribution or use would be contrary to local law or regulation.

This material is not a product of Santander´s Research Team and does not constitute independent investment research. This is a marketing communication and may contain ¨investment recommendations¨ as defined by the Market Abuse Regulation 596/2014 ("MAR"). This publication has not been prepared in accordance with legal requirements designed to promote the independence of research and is not subject to any prohibition on dealing ahead of the dissemination of investment research. The author, date and time of the production of this publication are as indicated herein.

This publication does not constitute investment advice and may not be relied upon to form an investment decision, nor should it be construed as any offer to sell or issue or invitation to purchase, acquire or subscribe for any instruments referred herein. The publication has been prepared in good faith and based on information Santander considers reliable as of the date of publication, but Santander does not guarantee or represent, express or implied, that such information is accurate or complete. All estimates, forecasts and opinions are current as at the date of this publication and are subject to change without notice. Unless otherwise indicated, Santander does not intend to update this publication. The views and commentary in this publication may not be objective or independent of the interests of the Trading and Sales functions of Santander, who may be active participants in the markets, investments or strategies referred to herein and/or may receive compensation from investment banking and non-investment banking services from entities mentioned herein. Santander may trade as principal, make a market or hold positions in instruments (or related derivatives) and/or hold financial interest in entities discussed herein. Santander may provide market commentary or trading strategies to other clients or engage in transactions which may differ from views expressed herein. Santander may have acted upon the contents of this publication prior to you having received it.

This publication is intended for the exclusive use of the recipient and must not be reproduced, redistributed or transmitted, in whole or in part, without Santander’s consent. The recipient agrees to keep confidential at all times information contained herein.