Last week's head-fake selloff and subsequent rally have
put MBS prices back in sight of their early-February (and all-time) highs. This in turn has forced investors to look for
ways to improve their investment results and carry-adjusted returns. Research over the last decade has
demonstrated that a number of attributes result in improved prepayment
performance-in a market where the weighted average dollar price is in the area
of 104, this means that investors want MBS with slower prepayment speeds. This
can accrue to the benefit of forward-thinking originators that can capture
at least some of these payups in their execution.
There are a number of
loan attributes that tend to result in
slower prepayments and/or reduced responsiveness to refinancing
incentives. The best-known attributes
are loans with smaller loan balances and impaired credit. Investors will pay significantly more than
TBA prices for pools backed by loans with these characteristics. As a result, the market for agency MBS has
created tiers in order to trade the variety of products being created; pools
backed by these loans trade as "specified pools" (or "spec pools") away from
the TBA market.
There are a number
of reasons that smaller loans tend to prepay relatively
slowly. Aside from the generally
lower incomes and financial strength of the borrowers, small loans have to
overcome significant hurdles in order to justify the fixed expenses involved
with refinancing. For example, a
borrower with a $230,000 loan can save about $67 a month by refinancing into a
loan with a 50 basis point lower rate.
If the total fixed costs of refinancing are $1,000, the borrower breaks
even in roughly 15 months. Borrowers
with an $85,000 loan, by contrast, would only reduced their P&I payment by
$25/month, meaning that it would take over 3 years to recoup their expenses.
Other specified pool
buckets have formed around credit characteristics. Loans
with weaker credit (such as low FICO scores and/or high LTVs) have long
tended to pay relatively slowly, since these borrowers have difficulty in getting
new loans. (Their prepayment advantage
is even more pronounced in a tight-credit environment.) There are also specified pool cohorts for
characteristics such as "brand new
loans." Since borrowers tend not to
refinance their loans immediately upon closing, these pools also tend to prepay
very slowly for a number of months after issuance. Finally, there are other new programs (such
as MHA/HARP) that also trade at a premium to TBAs.
"Generic" MBS (i.e.,
loans without any definable prepayment advantage) are delivered directly into
TBAs. A variety of separate segments
have developed, most commonly by loan size.
The most commonly traded tiers are for loans with maximum pool balances
of $85K, $110K, $125K, $150K, and $175K.
The key element is that these pools define the maximum loan balance in
the pool, not the average. This
improves the performance of the pool by limiting the size dispersion within the
segments are generally priced by coupon and attribute, and (at current prices)
are at very strong levels. Even some of the historically muted
prepayment stories, such as maximum-$150K conventionals, are trading extremely
The key for
originators is to monetize the incremental value of their spec pool
loans. While some correspondent lenders
will pay up for some loan attributes, most originators are forced to sell their
production at generic levels. In most
cases, selling loans in order to garner some of the market payups for the loans
means that originators need to have the authority to create their own pools and
hold the servicing for the loans.
Originators cannot maximize their revenues without taking advantage of
these payup opportunities.