By the Numbers
Relative value skews toward agency loans in private-label MBS
This material is a Marketing Communication and does not constitute Independent Investment Research.
A growing number of investors likely see better value owning agency exposure in private-label form. Despite the recent decline in specified-pool payups, private-label pass-throughs, particularly those backed by investor loans, continue to deliver attractive relative value for investors willing to give up the liquidity the agency market provides.
Valuations on specified pools have taken a hit recently as the combined effect of rising benchmark yields and persistently low interest-rate volatility has weighed on payups. At the same time, issuance of private-label deals backed by agency-eligible collateral has increased substantially. Depressed specified-pool valuations coupled with heavier private-label supply would imply that agencies should offer better relative value. Despite that, owning the exposure in private-label form may still look better.
Are the exposures really the same?
Gauging relative value starts with whether the exposures are truly like for like. The somewhat obvious answer is no. Moving away from TBA delivery is a major concession in both liquidity and the price at which the asset can be floored. Other structural differences exist as well. While both assets analyzed are nominally pass-through classes, the private-label exposure is more sequential in nature. The bonds that provide credit support to senior classes are locked out from prepayments for a period, making the senior classes more leveraged to those prepayments.
Other differences exist as well. Loans delivered into private-label execution consistently carry substantially higher average loan balances and higher LTVs. They tend to carry higher rates and more SATO despite substantially lower concentrations of cash-out refinances (Exhibit 1).
Exhibit 1: Comparing investor loans in conventional and private-label execution
Source: Santander US Capital Markets, CoreLogic LP
Higher-balance and higher-LTV pools with lower cash-out concentrations make sense within the private-label execution framework. Fixed costs associated with default, foreclosure and liquidation translate into lower fixed loss severities on larger loans. Conventional LTV-based pricing adjustments for investor loans are somewhat blunt, leaving room for more refined private-label pricing of credit enhancement. Conversely, cash-out refinances generally require substantially more credit enhancement than comparable purchase or rate-and-term refinance loans, making agency execution a more viable channel.
Higher average balances do not appear to be causing greater negative convexity in private-label trusts. Comparing S-curves for loans with similar balances in private-label trusts and agency pools shows that at-the-money speeds are actually slightly slower in private-label execution. Private-label loans prepay 2 to 4 CPR slower when deeply in the money. Slower in-the-money speeds on private-label loans may be attributable to servicing transfers from agency servicers, which are likely more efficient at refinancing these loans, to less efficient private-label servicers. That is despite the fact that these borrowers could just as easily refinance into another conforming loan (Exhibit 2).
Exhibit 2: Comparing S-curves on agency and PLS investor loans
Source: Santander US Capital Markets, CoreLogic LP
Measuring relative value with a constant OAS methodology
One way to establish a level playing field for relative-value analysis is to use an “equal OAS” methodology because OAS accounts for differences in structure and collateral. The analysis compares 5.5% and 6.0% coupon pass-throughs in private-label and specified-pool form. One important distinction between the two exposures is that coupon options in the private-label market are stripped from the same collateral group, while specified pools carry different gross WACs at different pass-through rates. The specified pools also have larger average loan balances.
The private-label 5.5% and 6.0% pass-throughs are priced 16/32 and 20/32 behind their respective TBA benchmarks. The specified pools are priced 0.5/32 and 6/32 above their TBA benchmarks. At these levels, the private-label pass-throughs offer 41 basis points and 54 basis points of OAS, while the agency pools deliver 18 basis points and 17 basis points, respectively (Exhibit 3).
Exhibit 3: An OAS comparison of PLS and agency exposures
Note: YieldBook uses different prepayment models for agency investor loans and agency-eligible investor loans securitized in private-label MBS. This may make OAS values and calculations that use the OAS values non-comparable.
Source: Santander US Capital Markets, YieldBook
Running the private-label pass-throughs to the same OAS as their agency counterparts pushes their theoretical values not only above TBA but also above the comparable specified pools. In reality, this pricing construct would never materialize for a couple of reasons. First, pools, even in the agency market, rarely trade at or near 100% of their theoretical value under a constant-OAS methodology. Second, and potentially more important, the market should and will demand a concession for the diminished liquidity associated with private-label execution.
However, the theoretical value does carry some weight. While private-label execution historically has skewed toward larger loans, that may become less pervasive as all loans get bigger, making fixed severities associated with liquidating those loans less important. In the examples above, the average loan size backing the PLS trust is roughly $150,000 to $200,000 smaller than that of the comparable pools, likely translating into more OAS on the private-label bonds. Additionally, the 6.0% private-label pass-through has substantially less option cost than the comparable pool because of its substantially lower gross WAC.
Accounting for credit and liquidity
While the equal-OAS methodology accounts 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. Regarding credit risk, all exposures are fairly pristine, with projected CDRs near zero. Assuming no material concession for credit, the analysis comes down to liquidity, which historically has been difficult to gauge. In periods of relatively muted volatility, investors appear to be more than adequately compensated to give up the liquidity associated with agency pools. In periods of elevated volatility, that may be less true.
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