October 11, 2018 07:08 PM GMT
​Agency Mortgage-Backed Securities Primer
​An Intuitive Guide to Mortgage Fundamentals
​Morgan Stanley Agency MBS Research
​Morgan Stanley & Co. LLC
​October 11, 2018
Due to the nature of the fixed income market, the issuers or bonds of the issuers recommended or discussed in this report may not be continuously followed. Accordingly, investors must
regard this report as providing stand-alone analysis and should not expect continuing analysis or additional reports relating to such issuers or bonds of the issuers.
Morgan Stanley does and seeks to do business with companies covered in Morgan Stanley Research. As a result, investors should be aware that the firm may have a
conflict of interest that could affect the objectivity of Morgan Stanley Research. Investors should consider Morgan Stanley Research as only a single factor in making
their investment decision.
For analyst certification and other important disclosures, refer to the Disclosure Section, located at the end of this report.
Morgan Stanley Agency MBS Strategy Team
Jay Bacow
Head of Agency MBS Strategy/Strategist
Executive Director
Jay.Bacow@morganstanley.com
+1 (212) 761-2647
Shuang Ji
Agency MBS Strategist/Strategist
Vice President
Shuang.Ji@morganstanley.com
+1 (212) 761-3340
Audyn Curless
Agency MBS Strategist/Strategist
Audyn.Curless@morganstanley.com
+1 (212) 296-8388
Zuri Zhao
Agency MBS Strategist/Strategist
Zuri.Zhao@morganstanley.com
+1 (212) 761-5429
AGENCY MBS PRIMER
MORGAN STANLEY RESEARCH
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Table of Contents
Section
Page
Overview
4
Prepays
27
Specs, Flow, and Trading
46
CMOs, Agency CMBS, and Agency Debt
61
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SECTION 1
Overview
Introduction to the Agency MBS Universe
AGENCY MBS PRIMER
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Market Overview
How big is the market, and who owns it?
Non-Agency
CMBS,
$0.5tn Agency
CMBS,
$0.6tn
Non-Agency
MBS, $0.8tn
Money
Markets,
$1.0tn
Agency
MBS, $6.2tn
Agency
Debt, $1.9tn
GSEs, $187bn
Money
Managers,
$841bn
Corporate,
$9.0tn
Treasuries,
$14.5tn
REITs, $252bn
Banks,
$2,220bn
Overseas,
$1,005bn
Municipal
Bonds,
$3.9tn
Fed, $1,695bn
ABS, $1.5tn
Source: SIFMA, eMBS, Morgan Stanley Research
• The US fixed income market is about $40 trillion in size, with Treasuries accounting for over a third of the market and
securitized products accounting for less than a quarter.
• The Agency MBS market is over $6.2tn in outstanding balance and is the second most liquid fixed income market after
Treasuries.
• The largest holders of Agency MBS are banks, who like their favorable capital treatment; the Federal Reserve, which
bought mortgages after the financial crisis but is now winding down its mortgage portfolio; overseas accounts that like
their liquidity and security, and money managers that are benchmarked to the index.
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US Mortgage Loan Basics
What is a mortgage?
•
An individual wishes to purchase a home but needs to borrow money to do so.
– The homeowner borrows the money from a lender, like Wells Fargo or Quicken, at a
certain rate and term.
– The rate depends on the general level of interest rates, the borrower’s income/credit
profile, and the type and length of the desired loan.
•
Loan mechanics:
– The borrower pledges the house as collateral against the mortgage loan.
– Down payment must be made up front (as little as 3%, typically about 18% of the
property value).
– Around 99% of the purchase loans have fixed monthly repayments, with about 85%
over 30 years (15 and 20-year terms are also popular).
– In a fixed loan, the constant monthly payments consist of:
•
Principal – money loaned to borrower (this starts off small and increases)
•
Interest – cost of borrowing the principal (this starts off large and decreases)
– Importantly, borrowers may prepay at any time without penalty, but they essentially
have to when they move.
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Mortgage-Backed Securities (MBS)
How is a Mortgage-Backed Security created?
•
An originator collects similar mortgage loans they have recently issued into a pool.
– Generally, they will pool together mortgages with similar characteristics, such as rate and loan size.
•
The originator then securitizes this pool and has it guaranteed by the government or a GovernmentSponsored Agency (GSE) .
– The agency charges a fee for guaranteeing the pool (around 50bp for GSEs).
– The government or GSE will guarantee the timely payment of both principal and interest.
– The mortgage servicer (often but not always the originator) charges a ~25bp servicing fee.
•
The originator may then sell this guaranteed security to a broker-dealer, such as Morgan Stanley, who turns
around and sells it to an investor, such as a pension fund or bank.
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The Role of Agencies in Securitization
What are the different agencies?
•
There are three agencies that guarantee mortgages: Fannie Mae, Freddie Mac, and Ginnie Mae.
– They are created by acts of Congress to support homeownership.
– Fannie Mae (FNMA) and Freddie Mac (FHLMC) are Government-Sponsored Entities (GSEs) and have
been under conservatorship since the financial crisis, and are relatively similar.
•
MBS backed by GSEs have an “implicit” government guarantee – presumably the US government
would step in and guarantee GSE debt in a time of financial stress.
•
Regulated by the Federal Housing Finance Agency (FHFA).
– Ginnie Mae (GNMA) is a government organization.
•
MBS backed by Ginnie Mae have an “explicit” government guarantee, and are backed by the full faith
and credit of the US government, just like Treasuries.
•
Primarily comprised of the Federal Housing Administration, which supports low-income housing, and
US Department of Veteran Affairs.
Current Outstanding MBS by Agency
Fannie Mae
Freddie Mac
Ginnie Mae
$2.7tn
43%
$1.8tn
28%
$1.8tn
29%
Source: eMBS, Morgan Stanley Research
AGENCY MBS PRIMER
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Why Do Investors Buy Mortgages?
What risks are Agency MBS investors taking and compensated for?
•
Investors make decisions based on the trade-off between risk and return.
•
Investors can get paid for many risks, but the dominant fixed income risks are duration, curve, liquidity,
supply/demand, credit, and convexity.
•
Since most mortgages are fixed-rate, they will tend to have positive duration.
– When interest rates rally, investors will pay more for a bond that has an above-market coupon.
– Alternatively, when rates sell off, investors will pay less for a below market coupon.
•
The shape of the yield curve determines forward expectations for interest rates. If the yield curve is upward sloping
and steep, that means that forward expectations for interest rates are much higher than the current, spot levels.
– Mortgages will have exposure across the yield curve as the shape of the yield curve will drive forward expectations
for mortgage rates in the same way as it drives expectations for forward interest rates.
•
Additionally, as the Agency MBS market is the second most liquid fixed income market (about $50bn will trade on
average in a given day), investors do not get compensated for taking much liquidity risk.
•
Like in any other market, Agency MBS investors are worried that an increase in supply relative to demand could drive
prices down and decrease returns.
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Why Do Investors Buy Mortgages?
What risks are Agency MBS investors taking and compensated for?
•
By definition, supply must equal demand. There are two types of supply that investors track: gross issuance and net
issuance.
– Gross issuance is the sum of all mortgages that are originated, and includes both loans that have been refinanced
as well as loans that have been issued to purchase a new home.
•
Gross issuance will increase if interest rates decline, causing an increase in refinancing activity. It is also
impacted by how many new homes are built and the general strength of the housing market.
•
Additionally, the securitization rate, which quantifies the percent of mortgages that banks securitize into MBS
vs. keep as loans on their balance sheet, greatly impacts gross issuance. Banks’ securitization rates will be a
function of balance sheet constraints as well as how much the Agencies charge to guarantee loans (G-fee) vs.
the expected losses on those loans.
– Net issuance is the change in size of the outstanding Agency MBS universe, and is dependent on the amount of
mortgages that are created and the amount of mortgages that are paid down in a given time period.
•
•
Generally, the net supply of mortgages is more impactful to investors than the gross supply, as net supply
represents additional bonds that investors must own.
•
Net issuance is less dependent on refinancing activity and therefore more dependent on purchase activity,
particularly new home sales.
•
Changes in the securitization rate also impact net issuance, along with home prices and average LTVs. (larger
average loan size means larger outstanding balance of mortgages).
Demand for Agency MBS is a function of general risk on/risk off trends, changes in regulations (such as capital
requirements for banks), and relative value compared to other asset classes, among other drivers.
AGENCY MBS PRIMER
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Why Do Investors Buy Mortgages?
What risks are Agency MBS investors taking and compensated for?
•
Unlike credit products, cash flows for Agency MBS are fully guaranteed for defaults and refinances by GSEs or the US
government, with investors getting their money back at par ($100) regardless of the current price of the security.
– Theoretically, there is some credit risk that the GSEs could default, which was a concern during the financial crisis.
– Additionally, each mortgage is secured by the property it references.
•
Therefore, an Agency MBS investor is not concerned if they get their money back, but rather when they get their
money back, and Agency MBS has minimal credit risk.
•
A borrower in the US can prepay their mortgage whenever they want (and basically must when they move).
– Borrowers will prepay more often when they have an economic incentive, i.e., they have access to a lower
mortgage rate than what they are currently paying.
– As rates rally, prices go up, and incentive to refi picks up, the duration of the mortgage shortens.
– This means that the price won’t go up by as much as the spot duration implies, and so MBS are negatively convex
due to this refinance (prepay) risk.
– The chance of a borrower having an incentive to refinance over the life of the loan will depend on how often the
mortgage rate falls below their current rate, which is a function of interest rate volatility over the life of the loan.
– Thus, mortgages investors are also short interest rate volatility.
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Prepays
What are prepays?
•
Although a typical mortgage is a fixed-rate coupon for 30yrs, most mortgages are prepaid before maturity. A “prepay” is
when a borrower pays down their mortgage balance faster than required. There are many types of prepays:
– If a borrower refinances, they pay off their current mortgage while simultaneously taking out a new mortgage. The
investor who owns the pool with the original loan will get their money back at par, while the new loan would go
through the origination process and (if securitized) end up in a new pool.
– A homeowner could move, paying off their current mortgage with proceeds from selling their house. In the US, a
borrower almost always has to pay off their mortgage before moving.
– A borrower could default, in which case the GSE that guaranteed the loan will buy out the delinquent mortgage and
result in a prepay for the investor.
– Borrowers that wish to take advantage of home equity or need cash quickly could do a cash-out refinance, in
which the borrow takes out a new loan that is larger than their current loan in order to withdraw cash from their
home’s equity.
– Borrowers can also curtail their mortgage, or simply pay off their mortgage balance faster than required to lower
future interest payments, without paying off the entire mortgage at once.
– Mortgages will also amortize due to the natural payment schedule, such that an investor that buys a 30yr pool with
a 5% rate at origination will have about 70% of it left after 15 years, 50% left after 20 years, and 25% left after 26
years even if there are no voluntary refinances.
AGENCY MBS PRIMER
MORGAN STANLEY RESEARCH
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Prepays
How do prepays impact cash flows?
​Cash flows without prepays
$/month
Interest
​Cash flows with prepays
Principal
400
$/month
500
Interest
Principle
400
300
300
200
200
100
100
0
Months->
Source: Bloomberg, Morgan Stanley Research
0
Months->
Source: Bloomberg, Morgan Stanley Research
Each payment is fixed, but the composition of the fixed
payment changes over time:
Prepayments occur when borrowers pay back more
principal than required in a given month.
•
Mostly interest at the beginning.
•
•
Mostly principal at the end.
•
Timing of prepayments is not known beforehand, so
prepayments accelerate the cash flows of a mortgage
at an unknown rate.
The higher the interest rate, the more principal
payments are “back-loaded.”
•
The faster a borrower prepays, the less interest the
lender receives.
Actual impact:
•
If an investor buys 100mm of a pool at $105, they will initially have spent $105mm.
•
If 2% of it refinances after one month, they will now have $2mm in cash and 98mm of the bond at $105, for a net value
of $104.9mm of cash and market value of the bond (i.e., they lost 5 points on 2% of their holdings).
AGENCY MBS PRIMER
MORGAN STANLEY RESEARCH
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Prepays
How do prepays impact the investor?
•
Prepays are correlated with interest rates – as rates move lower, more borrowers have an incentive to refinance to reduce
their mortgage rate, and vice versa.
•
Therefore, a mortgage-backed security’s duration is correlated to interest rates:
•
–
As rates rally, and people prepay their mortgage, the duration of the bond decreases – this is called call risk.
–
As rates sell off, and it becomes more costly to refinance at higher rates, people prepay slower and the duration
increases – this is called extension risk.
–
The probability of a borrower refinancing is largely based on the difference between the mortgage rate they are paying
and the current prevailing mortgage rate, otherwise known as the borrower’s incentive to refinance.
The borrower always has the option to prepay their mortgage, and the likelihood of prepayment is correlated with changes
in interest rates.
–
Therefore, an MBS investor is short a call option on interest rates.
Duration
7
6
5
10yr Yield
3
2.5
4
3
2
1
2
1.5
0
1
Jan-15 May-15 Sep-15 Jan-16 May-16 Sep-16 Jan-17 May-17 Sep-17 Jan-18 May-18 Sep-18
FN 3.5 Duration
10yr Yield (RHS)
Source: YieldBook, Morgan Stanley Research
AGENCY MBS PRIMER
MORGAN STANLEY RESEARCH
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Prepays
A risk for investors
Mortgage investors are negatively impacted by prepays in multiple ways:
•
Suppose an investor wishes to invest in the Agency mortgage market. They purchase $100mm FNCL 4.5s, which are securities with a 4.5%
coupon backed by 30-year mortgages guaranteed by Fannie Mae.
•
To avoid interest rate risk, the investor hedges the position with 10yr Treasuries.
–
•
•
The investor multiplies 100mm FNCL 4.5 * price of FNCL 4.5 * duration of FNCL 4.5 / (price of ten-year notes * duration of ten-year notes) =
number of ten-year notes to sell to be duration-neutral.
Rates subsequently rally 50bp. Lower interest rates cause higher expectations of refinancing, and therefore the duration of the MBS decreases,
resulting in several distinct effects:
–
The MBS price increases, but by less than expected, as its duration has shortened into the rally. However, the Treasury hedge’s duration has
barely changed (actually it has gotten longer, as Treasuries are positively convex), resulting in the hedge losing more money than the MBS
gained, due to MBS’s negative convexity.
–
Additionally, the MBS investor is no longer duration-neutral, and must re-hedge by buying back either Treasuries or mortgages at a higher
dollar price, losing money from delta hedging.
–
While the bond’s price is now above par, the investor gets their money back at par. As prepay speeds increase, the investor gets more of their
money back at par and must reinvest at new, lower rates.
If rates sell off and borrowers are more averse to refinancing, the bond’s duration extends, the investor must re-hedge by selling duration at lower
prices, and the investor gets money back slower so they can’t reinvest at the new higher rates.
Delta Hedging
Decreased Trading Profits
Negative Convexity
Prepays
Reinvestment Risk
Decreased Asset Value
Pull-to-par
AGENCY MBS PRIMER
MORGAN STANLEY RESEARCH
15
Prepays
Negative convexity
•
Negative convexity:
– Definitionally, duration is the derivative of change in price with respect to change in yield, or the amount by which a
bond appreciates in value as rates rally (and depreciates as rates sell off).
– As the duration of MBS decreases as rates rally due to refinances, MBS gain less value than a constant-duration
bond – likewise, into a sell-off, MBS duration extends as borrowers are less likely to refinance, and the bond loses
more money than a comparable non-mortgage bond.
– The investor is best off if rates stay constant – as they are short a call option on rates, they are also short rate vol.
– For example, consider a hypothetical bond priced at par with 7 years of duration and -4 years of convexity. If rates
rally from 3% to 2.5%, the bond’s price increases to $103 instead of $103.50 because the bond’s duration
decreases as rates rally.
103.50
103.00
100.00
80
UST
MBS
2.50%
AGENCY MBS PRIMER
3.00%
MORGAN STANLEY RESEARCH
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Prepays
Delta hedging
Negative convexity causes investors to lose money delta hedging a long MBS position.
•
If an investor is long MBS and short a duration-neutral amount of Treasuries, as rates rally their overall duration will
become negative, as their long MBS positions shortens.
–
To become delta-neutral again, the investor must buy more Treasuries at lower rates/higher prices.
•
Likewise, if rates sell off, the investor must sell Treasuries at a lower price to re-hedge.
•
The more rates move, the more frequently an investor must re-hedge, and the more money they lose delta hedging –
another reason why an MBS investor is short volatility.
•
Another feature of negative convexity is that mortgage performance is rate-path dependent, as MBS will yield less in
environments with volatile rates vs. environments with stable rates.
•
Investors are compensated for this by getting more yield in mortgages than they are in Treasuries.
PNL $0
Interest rates
AGENCY MBS PRIMER
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Prepays
Reinvestment risk and pull-to-par
•
Reinvestment risk:
– As bonds prepay faster as rates rally, the investor gets their money back faster than expected and must reinvest at
a lower rate.
– Similarly, as rates sell off, the investor gets their money back slower and is unable to reinvest at the new higher
rates.
•
Pull-to-par:
– Bonds are paid back and mature at par ($100). For a premium bond (price > $100), faster prepays mean principle
is returned more quickly, causing the bond’s inherent value to become closer to par.
– This effect is inverted for bonds trading at a discount.
•
Investors prefer slower prepays for premium bonds and faster prepays for discount bonds.
•
The further the bond is priced from par, the greater the impact of prepay speeds on the bond’s value.
– Investors will also typically prefer bonds that have more time to maturity (all else equal) for premiums to receive the
above market coupon for longer, and shorter bonds to maturity (all else equal) for discounts
AGENCY MBS PRIMER
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Mortgage Spreads
How do you measure MBS performance?
•
OAS vs. ZV
30
ZV
80
25
75
Current Coupon (CC) Spread to 5s/10s: Excess yield of the interpolated coupon priced at
par vs. the average of 5 and 10yr Treasury yields.
20
70
–
Pros: No model assumptions, very straightforward.
15
65
–
Cons: ignores impact of vol and prepays, only works on current coupon.
10
60
5
55
0
Jun-17
50
Mortgages are fundamentally a spread product, but since the question for mortgage investors is
when do you get your money back, not if, the spreads need to make assumptions about prepays:
•
OAS
Nominal spread: Excess yield over the same average-life Treasury at constant CPR
(prepayment speed).
–
Pros: Minimal model assumptions, works on all bonds.
–
Cons: Constant CPR, ignore curve risk, ignores vol risk.
Sep-17
Dec-17
OAS
OAS (bp)
•
•
Zero Volatility spread (ZV): Calculated spread based on expected future prepays assuming
rates follow the forward curve.
–
Pros: No volatility assumptions required so there are minimal differences between
models, accounts for curve risk.
–
Cons: Assuming volatility is zero means calculated yield is almost always higher than
realized yield as rates will move.
Option-Adjusted Spread (OAS): Calculates expected spread based on assumed interest
rate volatility.
–
Pros: Most accurate measure of expected spread vs. hedge, excess returns over life of
loan should approximate OAS on annual basis.
–
Cons: Complicated model means sometimes large differences between models exist;
needs to be fitted across all stories and thus reparametrized frequently.
AGENCY MBS PRIMER
Mar-18
Jun-18 Sep-18
ZV
Source: YieldBook
OAS History
75
55
35
15
-5
-25
-45
2003
2005
2007
2009
OAS
2011
2013
2015
2017
Average
Source: YieldBook
MORGAN STANLEY RESEARCH
19
Mortgage Spreads
The OAS approach
•
OAS is a fundamental component of measuring risk in the mortgage market, but it is highly model-dependent and inexact.
•
To calculate expected yield, an OAS model runs a Monte Carlo simulation over potential future interest rate paths.
–
Expected prepays are calculated for each simulated rate path, and the total expected spreadis the probability-weighted
average of the expected return over each rate path vs. the hedge’s return on that path.
•
OAS will equal the Zero Vol Spread (ZV spread) less the option cost (cost to delta hedge as function of volatility); as implied
volatility is an input to the model, OAS can tighten as vol increases – it is not uncommon to see ZV spreads widen, implied vol
increase, and OAS remain relatively unchanged.
•
In order to earn the OAS, you will need to hedge out all of your curve risk and then either buy back your negative convexity in the
swaption market, or delta hedge daily.
•
The OAS model will also output OAD, OAC, partial durations, and other model-based metrics.
•
OAS models do a reasonable job in general, but are less accurate modeling more specific subsets of the market.
Future interest rates
Option Adjusted Spread (OAS)
Implied rate volatility
Option Adjusted Duration (OAD)
OAS Model
Expected mortgage prepays
Option Adjusted Convexity (OAC)
Mortgage loan-level characteristics
Volatility Exposure
Source: Morgan Stanley Research
AGENCY MBS PRIMER
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Example MBS
Identifiers
FNCL 4.5
Value
Name
Description
FNCL
Ticker
FNCL represents 30yr, fixed-rate MBS guaranteed by Fannie Mae. Other common
tickers are FNCI for 15yr MBS, FNCT for 20yr, FGLMC is 30yr fixed-rate MBS
guaranteed by Freddie Mac, and G2SF for 30yr MBS guaranteed by Ginnie Mae.
Coupon
Coupons are issued in 0.5% increments and current actively-traded coupons range
from 3 to 5.5 for 30yr maturities.
Price
Represents a percent of par, and is measured in dollars (103) plus ticks (19/32)
4.98
Weighted Average
Coupon (WAC)
The weighted average coupon of the underlying mortgages – generally, lower WACs
are better.
8
Weighted Average
Loan Age (WALA)
The weighted average age of the underlying mortgages is a large factor in
determining how fast a mortgage-backed security is currently prepaying.
Weighted Average
Original Loan Size
Investors value pools with smaller average original loan sizes.
4.5
Model
Outputs
Collateral
Characteristics
103-19
$349,483
6.47
Average Life
Despite the mortgages in this pool having 30yr terms, the average life is much
shorter due to prepay expectations.
5.25
Modified Duration
The bond’s short duration is a reflection of the bond’s embedded prepayment risk.
-2.96
Convexity
Convexity is the derivative of duration (and the second derivative of change in price
with respect to change in yield). It measures how much the bond’s duration changes
based on rate changes.
3.80
Yield
Nominal yield.
84
ZV
Zero volatility spread to Treasuries.
28
OAS
Option-Adjusted Spread is the most accurate estimation of actual future spread.
Source: YieldBook, Bloomberg
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21
TBA
Futures market for MBS
•
If an investor wants exposure to MBS, they can either buy a pool outright or buy a futures contract called “TBA”, which
stands for “To Be Announced.”
•
Much of the daily volume of MBS that is traded occurs in the TBA market, and TBA is what makes the mortgage
market so liquid.
– TBA represents a futures contract for a mortgage-backed security that meets basic guidelines for good delivery as
defined by SIFMA.
– A TBA contract specifies agency, coupon, term, settlement date, quantity, and price, but the seller has the option to
deliver whichever pools they want at settlement as long as they follow good delivery guidelines.
– A seller will deliver the worst pools they are allowed to – therefore, the price of the TBA is a reflection of both what
market participants think the cheapest to deliver (CTD) pools are for that coupon/product and what investors think
the fair value of those pools is.
•
Generally, the CTD for premium bonds will be the fastest prepaying mortgages with enough outstanding
balance to be actively traded (and the slowest prepaying mortgages for discount bonds, as the investor gets
their money back at par).
– When the TBA settles, typically in the second and third weeks of each month, an investor that is long TBA has the
option to take delivery of pools or delay settlement by rolling their TBA position forward to the next month.
•
“48 hour day” occurs two days before settlement date. An investor that is long TBA must decide if they are
rolling or taking delivery by 48 hour day. Simultaneously, an investor that is short TBA must decide which pools
they will deliver – i.e., determining which bonds they own that are the worst.
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TBA
Dollar roll
•
The dollar roll is one of the most important features of the TBA market.
•
An investor who is long TBA, i.e., has bought a contract to receive MBS in the future, can “roll” their futures position by simultaneously selling
the contract they are currently long and buying the contract for the subsequent month.
•
The price difference between the front month TBA and back month TBA is called the drop. Investors who are long TBA can sell the roll (by
selling the front month and buying the back month) and earn the drop each month, as the back month price is almost always below the front
month price. This is rolling their purchase to the next settlement month.
•
The investor’s decision on whether to roll their position or take delivery of bonds is based on several factors:
–
The expected value of the pools they would get delivered: the exact pools an investor receives are unknown until settlement, so the market
has to estimate what the value of the CTD is. First, the market estimates what the collateral characteristics of the CTD are, such as
seasoning and average loan size. Next, the market estimates how fast that collateral will prepay – the resulting speed is represented by the
implied CPR of the roll.
•
For premium bonds, higher implied prepay speed results in lower value from selling the roll (rolling long TBA positons to the next
month), and for discount coupons, lower implied speeds result in lower value from selling the roll.
–
The size of the drop (the price difference between the two months): the larger the drop, the cheaper the investor can buy the back month
TBA contract vs. selling the front month, and the more likely they are to roll their position vs. taking delivery of pools.
–
The financing rate: measures the opportunity cost of using balance sheet to take delivery of pools. One way to think about the financing rate
is the lowest risk-free rate an investor can invest at where selling the roll is equally as attractive as holding pools on their balance sheet.
•
For a given coupon and product, there are three variables that determine how the roll trades: drop, implied CPR, and financing rate. Fixing any
two of these variables defines the value of the third variable.
•
If the implied financing rate of the roll is lower than the risk-free rate available to an investor, then the roll is trading “special”.
AGENCY MBS PRIMER
MORGAN STANLEY RESEARCH
23
TBA
Dollar roll example
•
An investor is long $100mm FNCL 4.5 TBA for October 11 settle. On 72 hour day, 3 days before settlement, most
investors will decide whether to roll their position forward or take delivery of pools.*
•
Currently, the roll is trading with a 4 tick drop and short-term funding rates are 2.3%. Using Bloomberg’s RA screen, the
investor calculates that the roll has an implied prepay speed of 18 CPR.
•
If the investor takes delivery, they will be responsible for the prepays that occur in October (but they will also receive
the coupon). If they roll, they can take the cash from rolling their position and invest in low-risk short term assets.
•
Currently, the investor thinks FNCL 4.5s will pay 15
CPR in Oct, not 18. At 15 CPR, the drop is worth
4.32 ticks. Therefore, the investor decides to take
delivery of pool as that offers more value.
•
Now consider if the investor thought the implied CPR
of 18 was accurate, but was able to invest at 2.4%
instead of 2.3%. The investor would sell the roll as
their investment rate is higher than the breakeven
financing rate that the roll is trading to.
*(They don’t have to decide until 3pm on 48 hour day,
but if they want to net out their trades, it must be done
by 72 hour day.)
Source: Bloomberg
AGENCY MBS PRIMER
MORGAN STANLEY RESEARCH
24
Carry
Pools and rolls
•
Fundamentally, an investor makes money because either their bond appreciates vs. their hedge (spread tightening) or collecting
coupon payments (carry).
•
You can think of carry as the amount by which a security’s cash flows exceed the cost of financing, i.e., the dollar amount the
investor makes per unit of time.
•
TBAs do not pay coupon payments, but should get more price appreciation if rolls are trading special and thus their prices look
more attractive (lower) when settled in the future, whereas pools get the actual coupon payments.
•
Investors compare the carry of taking delivery of pools to the carry of “rolling” a long TBA position forward to the next month.
–
•
If the market was perfectly efficient, the amount an investor would earn by taking delivery and holding the securities (i.e., the
“carry”) and the amount they would earn by rolling (i.e., the “drop”) and reinvesting their cash would be equal.
Historically, rolls traded special when the Fed was buying, but now they are trading cheap.
Carry from Holding Pool
+ Coupon (i.e., interest)
Carry from Rolling (Drop)
=
+ Buy TBA at a lower price in the next month
- Scheduled principal
+ Reinvestment of cash for the month
- Prepaid principal
+ Free balance sheet
- Balance sheet tied up for a month
- No actual coupon payment
AGENCY MBS PRIMER
MORGAN STANLEY RESEARCH
25
Hedging
Treasuries, swaps, and swaptions
•
Investors who are long MBS have both duration and convexity exposure that they can hedge.
•
Duration exposure can be hedged with Treasuries or swaps:
– Hedging with just 10yr Treasuries is simplest form of hedging, but as the duration of the 10yr is ~8.5yrs and the
duration of MBS is ~4-7yrs, the investor is inherently in a steepener trade if they hedge a long MBS positon by just
shorting 10yr USTs.
– Hedging with a blend of 5yr and 10yr Treasuries offers more attractive curve exposure than just using the 10yr.
– OAS models can calculate detailed partial duration exposure to each part of the curve, and many investors will use a
hedging strategy that hedges 2yr, 5yr, 10yr, and 30yr exposures. However, this is a more complex hedging solution
that incurs potentially greater transaction costs.
– These strategies can all be replicated with swaps instead of USTs, or Treasury futures as well.
•
After hedging out duration exposure, the investor is still short convexity/vol. Therefore, they can buy swaptions to
decrease their vol exposure. Only some investors will hedge out their vol exposure, as cost of buying swaptions eats into
the mortgage’s carry.
•
Investors who are long specified pools (pools that offer marginal protection from prepayments) often hedge with a short
TBA position instead of rates – that way, the investor is long a less negatively convex asset and short a more negatively
convex asset, so they are net long vol/long convexity.
AGENCY MBS PRIMER
MORGAN STANLEY RESEARCH
26
SECTION 2
Prepays
A Deep Dive into Prepayments
AGENCY MBS PRIMER
MORGAN STANLEY RESEARCH
27
Prepayments
How do investors analyze prepayment speeds?
•
When borrowers prepay, money comes back to the investor at par, and all forms of prepays (i.e., refinance or default)
look the same to the investor since principal and interest payments are fully guaranteed.
•
As prepay risk is the primary risk that mortgage investors face, many types of investors spend much time and energy
analyzing prepayment speeds.
•
Any given MBS’s prepayment speed can be broken down into a turnover component and a refinance component:
•
Turnover accounts for prepays that are not due to interest rate incentive, which include mobility, defaults, and cash
outs refinances.
•
Refinancing speeds are primarily driven by changes in interest rates, and different borrowers have different
sensitivities to rate changes.
Homeowners take out new
mortgages at the prevailing
market rate and pay back any
outstanding principal on the
original loan.
Prepayments
Homeowners prepay their
mortgages regardless of their
interest rate incentive.
Turnover
Mobility
AGENCY MBS PRIMER
Refinancing
Defaults
Cash Out
MORGAN STANLEY RESEARCH
28
S Curves
Visualizing prepay speeds by refinancing incentive
•
S-curves visualize the relationship between the incentive
borrowers have to refi and their prepay speeds.
•
They are typically constructed for bonds that are up the WALA
ramp.
•
S-Curves can be: shifted up/down, shifted right/left (elbow shift),
and steeper/flatter.
•
An S-curve shifted up indicates faster prepayments across
incentive levels and shorter duration.
•
An S-curve shifted right indicates borrowers need more rate
incentive before refinancing.
•
The steeper the S-curve, the more negatively convex the security
is, as prepays increase faster when rates rally.
•
Investors want (and will pay for) flatter S-curves.
•
This reduces the negative convexity of a bond and makes it
easier to hedge.
•
When borrowers are in the money (“ITM” – have higher
mortgage rates and positive incentive), investors would like
them to pay slower because they receive their money back at
par and lose their premium.
•
When borrowers are out of the money (“OTM” – have lower
mortgage rates and negative incentive to prepay), investors
would like them to pay faster because they receive their
money back at par for discounts.
AGENCY MBS PRIMER
Speed
No matter how large the
economic incentive to refi
is, some borrowers will
not refi (e.g., due to
disinterest or lack of
availability).
No matter how little their
economic incentive to refi
is, some borrowers will
always prepay due to
turnover reasons.
-1%
Incentive to Refinance
+1%
Source: Morgan Stanley Research
Generic S-Curve
Shifted Up S-Curve
Steeper S-Curve
MORGAN STANLEY RESEARCH
29
WALA Ramp
Visualizing prepay speeds by loan age
•
•
WALA (“Weighted Average Loan Age”) ramps
visualize the relationship between loan age and
prepayment speeds.
People usually do not prepay immediately after
taking out a mortgage because of the high up-front
cost associated with moving/refinancing.
•
As mortgages age, they go “up the ramp,” with
speeds increasing steadily for about 12-24 months.
•
Once the loans stop increasing in prepay speed,
they are considered “fully ramped.”
•
Eventually, speeds begin to decline gradually, as
borrowers “burn out” and are less likely to refi
based on rate incentive.
•
Speed
This is due to many reasons, but the biggest is that
the borrowers that are most efficient refinance first,
leaving borrowers that will have a harder time
refinancing left in the loan over time.
AGENCY MBS PRIMER
Slowdown in
prepayment speeds in
the later years can be
attributed to burnout.
Homeowners will prepay
slowly immediately after
taking out a new
mortgage.
0
Loan age (months)
96
Source: Morgan Stanley Research
MORGAN STANLEY RESEARCH
30
•
Measuring prepayment speeds
•
Prepayment speeds are calculated based on the
amount of unscheduled principal returned to investors.
•
SMM (“Single Monthly Mortality” Rate): The monthly
prepayment rate of the security’s mortgage pool.
•
CPR (“Conditional Prepayment Rate” or “Constant
Prepayment Rate”): The annualized percentage of the
existing mortgage pool expected to prepay in a year.
•
Month 5 Balance
$9,828,988
Month 6 Balance
$9,789,239
Total Principal Paid
$9,828,988 - $9,789,239 = $39,749
Scheduled Principal
Paid
$15,234 (usually obtained from
servicer records)
Prepaid Principal
$39,749 - $15,234 = $24,515
SMM
$24,515 / ($9,828,988 - $15,234)
0.25%
CPR
1- (1-SMM)12 = 1-(1-0.25%)12
= 2.96% (approximated by SMM *12)
CPR assumes that the prepayment speed of the
security is constant for life. However, with the WALA
ramp, we know that prepays follow a general pattern.
AGENCY MBS PRIMER
•
•
PSA Model: Divides the pool’s life into two periods to
more accurately account for the WALA ramp.
–
Initial 30 months: Assumes the pool’s
prepayment speed (CPR) increases linearly.
–
After month 30: Assumes constant speed for
pool’s remaining life.
Ex. 100% PSA (aka 100% of the model)
–
Month 1 speed: 0.2% CPR
–
Prepay speed increases by 0.2% CPR until
reaching 6% CPR in month 30.
–
Speed stays at 6% CPR for remaining life.
PSAs are quoted as percentage of base model (250%
PSA implies that for every month the base model CPR
is multiplied by 2.5).
16%
14%
12%
10%
8%
6%
4%
2%
0%
CPR
SMM, CPR, and PSA
1 6 11 16 21 26 31 36 41 46 51 56 61 66 71 76 81 86
100% PSA Mon ths
250% PSA
Source: Morgan Stanley Research
MORGAN STANLEY RESEARCH
31
Refinancing
Prepayments
What is refinancing?
•
If the prevailing mortgage rate is lower than a borrower is currently paying on their mortgage, they can
refinance their mortgage to lower their monthly interest rate payments.
•
To refi, homeowners take out a new mortgage at the prevailing interest rate and pay back the
outstanding principal on the original loan.
•
As interest rates rally, borrowers have an increasing economic incentive to refinance, and are more
likely to prepay their existing mortgage.
•
However, there are fixed costs to refinancing including closing costs and appraisal fees.
Turnover
Refinancing
Factors that affect refinancing:
Rate Incentive
A borrower’s incentive to prepay is the difference between their current loan rate and the prevailing market
rate. The greater this difference, the more a borrower can save by refinancing.
Dollar Incentive
This is the actual amount of money a borrower can save by refinancing on a monthly basis. Larger loans
will have a greater monthly saving for the same rate incentive.
Time & Effort
A homeowner needs to put significant time and effort into refinancing their mortgage, and they also need
time to recoup the closing costs associated with the process. Many borrowers look at how many months it
takes to make back their closing costs.
AGENCY MBS PRIMER
MORGAN STANLEY RESEARCH
32
Refinancing
Prepayments
Factors that affect refinancing
Turnover
Refinancing
Media Effect
Due to media coverage and general
cultural exposure, as mortgage rates
approach or go below historical
thresholds, borrowers tend to
refinance and prepay faster than
they would based on rate incentive
alone.
120
0
100
0.5
1
80
1.5
60
2
Burnout
The slowdown of refi response when rate
incentive is high. Burnout may occur for
multiple reasons: Borrowers may have
already seen the lower rate before,
borrowers that would refinance may have
already done so earlier in the interest
rate drop cycle, and/or borrowers may be
unable to refinance due to their particular
situation (e.g., job loss, lack of
documents, etc).
AGENCY MBS PRIMER
40
2.5
20
3
0
9/16/2013 9/16/2014 9/16/2015 9/16/2016 9/16/2017
3.5
"Mortgage Refinance" Google Searches
10yr Yield (RHS)
Source: Google, Bloomberg, Morgan Stanley Research
MORGAN STANLEY RESEARCH
33
Refinancing
Prepayments
Factors that affect refinancing
Turnover
Loan Size
The larger the loan, the faster borrowers
recover the fixed costs of refinancing and the
faster they tend to prepay. Homeowners with
higher income also tend to take out larger loans
and may be more sophisticated and more
financially equipped to prepay and pay closing
costs.
Standard stratifications for loan size are:
CPR
When OTM, lower loan
sizes refi faster because
their monthly payments
would increase by less
with a higher rate. These
homeowners may also be
in starter homes and more
likely to upsize and move
into a larger home, even
when rates are higher.
Refinancing
35
30
25
20
15
• Low loan balance (LLB: $85,000 max)
• Mid loan balance (MLB: $85,001 – $110,000)
10
• Mid-high loan balance (MHLB: $110,001 –
$125,000)
5
• High loan balance (HLB: $125,001 –
$150,000)
• Very high loan balance (VHLB: ($150,001 –
$175,000)
• 200K max loan balance (200K : $175,001 –
$200,000)
AGENCY MBS PRIMER
-1
-0.75
-0.5
-0.25
0
0.00
0.25
0.5
0.75
1
Incentive
LLB
MLB
HLB
VHLB
Max 200K
TBA
Jumbo
Source: eMBS, Morgan Stanley Research
MORGAN STANLEY RESEARCH
34
Refinancing
Prepayments
Factors that affect refinancing
Turnover
Loan Level Price Adjustment (LLPA)
Refinancing
• Levied by Fannie and Freddie.
• LLPAs are charges for additional risk factors, such as low credit scores, high LTV, and loan purpose.
• Borrowers pay them either through an interest rate increase that continues for the life of the loan (more
typical) or as an additional closing cost.
Fannie LLPA Example:
LTV
Investment
Property
≤ 60%
>60 –
70%
>70 –
75%
>75 –
80%
>80 –
85%
>85 –
90%
>90 –
95%
>95 –
97%
>97%
2.125%
2.125%
2.125%
3.375%
4.125%
4.125%
4.125%
4.125%
4.125%
0%
0.25%
0.25%
0.5%
0.25%
0.25%
0.25%
0.75%
0.75%
0.5%
1.5%
3%
3%
3.25%
3.25%
3.25%
3.75%
3.75%
FICO ≥ 740
FICO < 620
Source: Fannie Mae
AGENCY MBS PRIMER
MORGAN STANLEY RESEARCH
35
Refinancing
Prepayments
Factors that affect refinancing
Turnover
High LTV
Refinancing
High loan-to value (LTV) loans historically prepay slowly as credit-constrained borrowers
should have fewer refinancing options. In addition to fundamental borrower credit
characteristics, high LTV loans also face higher LLPAs (an added cost for borrowers that
drives down prepay speeds).
Low FICO
As with high LTV pools, loans to borrowers with weak credit and high FICOs tend to prepay
slowly (since they pay higher rates and also have higher LLPAs).
-1
-0.75
-0.5
AGENCY MBS PRIMER
CPR 35
CPR 35
30
30
25
25
20
20
15
15
10
10
5
5
0
0
0.25
0.5
0.75
1
Incentive
Low Fico
TBA
LTV
Source: eMBS, Morgan Stanley Research
-0.25
0
1
3
5
7
9 11 13 15 17 19 21 23 25 27 29
Low Fico
Months
TBA
LTV
Source: eMBS, Morgan Stanley Research
MORGAN STANLEY RESEARCH
36
Refinancing
Prepayments
Factors that affect refinancing
Turnover
Investor
Refinancing
Investor pools are made up of mortgages that have been taken out for investment purposes.
They are not owner-occupied properties and tend to refi slower. They also have additional LLPAs.
Geography
Different states have different rules, demographics, and economic conditions, causing them to
display different prepay characteristics. For instance, due to state-specific taxes and fees
associated with refinancing, NY prepays slowly. Puerto Rico also tends to prepay slowly due to
their less-developed banking infrastructure. Conversely, CO prepays fast, most likely due to
strong economic activity and robust home price growth.
CPR 50
CPR 45
45
40
40
35
35
30
30
25
25
20
20
15
-1
-0.75
-0.5
TBA
AGENCY MBS PRIMER
-0.25
NY
15
10
10
5
5
0
0
0.25
0.5
0.75
1
Incentive
CO
PR
CA
Source: eMBS, Morgan Stanley Research
0
1
3
5
TBA
7
9 11 13 15 17 19 21 23 25 27 29
Months Since Issuance
NY
CO
CA
Source: eMBS, Morgan Stanley Research
MORGAN STANLEY RESEARCH
37
Refinancing
Prepayments
Factors that affect refinancing
Turnover
Refinancing
Loan Purpose
Mortgages are either taken out for purchase or for refinancing. Loans for purchase tend to prepay slower
than loans for refinancing. The refi borrower will have both more experience with the refi process and
probably fewer economic restrictions.
CPR 40
CPR 35
35
30
30
25
25
20
20
15
15
10
10
5
5
0
0
-1
-0.75 -0.5 -0.25
Purchase
0
0.25
Incentive
0.5
0.75
1
Refinance
Source: eMBS, Morgan Stanley Research
AGENCY MBS PRIMER
1
4
7
10
13
16
19
22
25
Months
Purchase
Refinance
28
Source: eMBS, Morgan Stanley Research
MORGAN STANLEY RESEARCH
38
Refinancing
Prepayments
Factors that affect refinancing
Turnover
Refinancing
Origination Channel
Mortgage loans from smaller, third-party originators (TPOs) tend to prepay faster because of incentive
structure. At TPOs, employees may be compensated primarily from closing costs, and therefore are
incentivized to refinance mortgages at a faster pace compared to larger lenders who might be worried
about being perceived by the market as especially “fast.”
CPR
CPR
40
35
35
30
30
25
25
20
20
15
15
10
10
5
5
-1
-0.75
-0.5
0
0
0.25
0.5
Incentive
Retail
TPO
-0.25
0
0.75
1
Source: eMBS, Morgan Stanley Research
AGENCY MBS PRIMER
1
3
5
7
9 11 13 15 17 19 21 23 25 27 29
Months
TPO
Retail
Source: eMBS, Morgan Stanley Research
MORGAN STANLEY RESEARCH
39
Refinancing
Prepayments
Factors that affect refinancing
Turnover
Servicer
Refinancing
Certain mortgage servicers are more efficient about refinancing than others. Loans originated by large
banks (like Wells Fargo) tend to prepay slower, while loans originated by Quicken tend to pay faster. This
may also be a function of the differences in the technology and marketing investments.
For conventionals, the servicer distribution has remained roughly constant over the last few years.
However for Ginnies, big banks now represent a smaller percentage of overall servicers.
100%
90%
Servicer Percentage
CPR 30
25
20
15
10
80%
70%
60%
50%
40%
30%
20%
10%
5
0%
0
-1
-0.75
-0.5
Quicken
-0.25
0
0.25
Incentive
Wells Fargo
0.5
0.75
1
Others
Source: eMBS, Morgan Stanley Research
AGENCY MBS PRIMER
Other - Conv
Other - Ginnie
Large Banks - Conv
Large Banks - Ginnie
Quicken - Conv
Quicken - Ginnie
Source: eMBS, Morgan Stanley Research
MORGAN STANLEY RESEARCH
40
Mobility
Prepayments
What is mobility?
•
Turnover
Aside from refis, prepays also come from turnover. Mobility, or people moving, is a major
component of turnover, and people can sell their house and move for a variety of noneconomic reasons:
–
Mobility
Refinancing
Defaults
Cash Out
Upsize/downsize, family circumstances, new jobs, and death/divorce, among others.
Factors that affect mobility:
Rates
Rising mortgage rates make homeowners less willing to sell their house because they don’t want to trade an
old, low-rate mortgage for a new, higher-rate one. The greater the difference would be between the new
(higher) monthly payment and current one, the more OTM a mortgage is, and the slower it prepays – this is
called the lock-in effect.
Seasonality
People tend to move more in late spring/summer because of the school calendar and warmer weather,
making it more convenient to search for houses.
Economy
In a healthy economy, income increases, driving mobility higher as people upsize houses and move for new
jobs. Of course, higher mortgage rates can mitigate this to some extent.
AGENCY MBS PRIMER
MORGAN STANLEY RESEARCH
41
Mobility
Prepayments
Indicators
Turnover
The Mortgage Bankers Association’s
weekly measurements of nationwide home
purchase and refinance loan applications
Signed real estate contracts
for existing homes that have
not yet closed
Completed sales
for existing homes
Mobility
Refinancing
Defaults
Cash Out
MBA Purchase Index
Pending Home Sales
Existing Home Sales
MBA Refinancing Index
Building Permits
Units under
Construction
Housing Starts
The number of permits The number of new
that have been issued housing units (or
for new construction
buildings) that have
been started
The number of new
housing units (or
buildings) being
constructed
Completed Units
The number of new
housing units (or
buildings) that have
been completed
New Home Sales
Completed sales for
new homes
Existing Home Sales
We can see the effect of seasonality from
Existing Home Sales, which peaks in the
summer and troughs in the winter.
Units (Millions)
AGENCY MBS PRIMER
May-18
Jan-18
Sep-17
May-17
Jan-17
Sep-16
May-16
Jan-16
Sep-15
May-15
Jan-15
Sep-14
May-14
Jan-14
Sep-13
May-13
Jan-13
Sep-12
0.7
0.6
0.5
0.4
0.3
0.2
0.1
0
Since around 2013, home sales had been
trending higher due to cheap housing and
low mortgage rates. However, recently we
see home sales slowing due to a lack of
construction and declining affordability.
Source: Bloomberg
MORGAN STANLEY RESEARCH
42
Cash Outs
Prepayments
What are cash outs?
•
Turnover
If a homeowner’s property appreciates in value, or they pay down their mortgage balance, the
borrower can choose to “cash out” this additional equity (potentially to pay off other debts, or
just to monetize the appreciation of their house’s value).
•
The borrower can refinance the existing loan into one with a higher principal balance (doing so
converts the homeowner’s equity into cash).
•
Even when mortgage rates rise above the borrower’s existing loan rate, the need for cash can
still drive cash-out refinancing activity.
Mobility
Refinancing
Defaults
Cash Out
Factors that affect cash outs:
Home Price Appreciation (HPA)
Home price appreciation creates the equity needed for a cash-out refinance. The larger the percentage
increase in home value, the more likely home-owners will do a cash-out refinance.
Credit Availability
Increased access to credit and easing lending standards make it easier for homeowners to obtain a cashout refi.
Rates
Homeowners are more likely to cash-out refi when rates rally as their new loan would have a lower
interest rate.
AGENCY MBS PRIMER
MORGAN STANLEY RESEARCH
43
Defaults
Prepayments
What are defaults?
Turnover
•
A borrower that fails to make a mortgage payment is considered delinquent (30 days delinquent for the
first missed payment, 60 days for the second, etc)
•
After missing three payments, the borrower is considered to be in default for the agency’s purpose
•
For Agency-guaranteed loans, the Agency arranges for scheduled principal and interest to be paid to
the investor if the borrower defaults.
Mobility
–
Agencies may buy out non-performing loans from the poolto reduce costs of paying continued
interest.
–
The GSEs (Fannie and Freddie) will usually buy out mortgages that are 120 days delinquent,
while Ginnie will typically wait longer.
•
To the investor, prepayments from defaults are indistinguishable from other types of prepayments.
•
Fannie does not provide loan level information about its defaults, but Freddie and Ginnie do.
Refinancing
Defaults
Cash Out
Factors that affect defaults:
Credit quality (FICO, DTI)
The lower a homeowner’s credit and debt
to income, the more likely that they are to
default.
Economy
Agency
Home Prices
FHA has the highest defaults, followed by
VA and conventionals.
Similarly, if a borrower’s home has depreciated in
value and they are underwater on their loan, default
rates are higher.
AGENCY MBS PRIMER
In a recession or a depression, the financial health of
borrowers suffers and defaults rise.
MORGAN STANLEY RESEARCH
44
Defaults
Prepayments
Factors that affect defaults:
Turnover
Mobility
Refinancing
Defaults
Cash Out
Incentive
The lower the borrower’s monthly payments are, the lower their default rate. This makes sense as
borrowers who secure the lowest interest rates typically have the strongest credit profiles.
Seasonality
With defaults, involuntary speeds are highest during the winter and lowest during the spring and summer,
presumably related to tax refund payments.
Ginnie Default Rate by Month of Year
0.24%
Freddie Historical Default Rate
10%
9%
8%
7%
6%
5%
4%
3%
2%
1%
0%
0.22%
0.20%
0.18%
0.16%
0.14%
0.12%
0.10%
1
2 3
2015
AGENCY MBS PRIMER
4
5
6 7 8 9 10 11 12
2016
2017
Source: eMBS, Morgan Stanley Research
1999 2001 2003 2005 2007 2009 2011 2013 2015 2017
Freddie Default Rate
Source: Freddie Mac
MORGAN STANLEY RESEARCH
45
SECTION 3
Specs, Flow, and Trading
Specified Pools, Flow Products, and Common Trading Strategies
AGENCY MBS PRIMER
MORGAN STANLEY RESEARCH
46
15s
15-year mortgages
•
With a shorter-term mortgage, a borrower’s mortgage payments will be higher but they will pay less interest (receive a
lower rate) for the same-sized mortgage.
–
For example, a borrower may pay 4% interest on a 30-year $100,000 mortgage ($477.42 monthly payment) but
pay 3.5% on a 15-year $100,000 mortgage ($714.88 monthly payment).
•
15s have less negative convexity than 30s because they have a shorter final maturity, and thus less
contraction/extension risk than 30s.
•
When the curve is steep, the 15yr mortgage rate will be much lower than the 30yr mortgage rate, as the expectation is
that in the future mortgage rates will be higher.
•
Banks and other investors with a preference for shorter, more bulleted cash flows prefer 15s. This causes them to
typically trade tighter than 30s.
OAS (bp)
30
25
20
15
10
5
Conv 30-yr OAS
AGENCY MBS PRIMER
09/18
08/18
07/18
06/18
05/18
04/18
02/18
03/18
01/18
12/17
11/17
10/17
09/17
08/17
07/17
06/17
05/17
04/17
02/17
03/17
01/17
0
15-yr OAS
Source: YieldBook, Morgan Stanley Research
15s/30s
0.80
0.75
0.70
0.65
0.60
0.55
0.50
0.45
0.40
0.35
0
15s/30s CC Yield Difference vs Curve
50
100
150
2s10s Curve
Source: Bloomberg, Morgan Stanley Research
MORGAN STANLEY RESEARCH
47
Ginnies
Ginnie Mae-guaranteed mortgages
•
While Ginnie Mae explicitly guarantees the timely payment of principal and interest just as Fannie and Freddie do
implicitly, Ginnie-guaranteed mortgages also differ from Fannie- and Freddie-guaranteed ones in their underlying
collateral composition.
•
GNMA’s securities are collateralized by mortgages guaranteed or insured by:
•
•
•
–
Federal Housing Administration (FHA): Helps low-income borrowers obtain mortgages, makes up about 60%
of Ginnie-guaranteed mortgages.
–
Veteran Affairs (VA): Helps veterans and service members obtain mortgages, about 35% of Ginnie-guaranteed
mortgages.
–
Rural Housing Service (RHS) and Public and Indian Housing (PIH): About 5% of Ginnie-guaranteed
mortgages.
The explicit guarantee and better capital treatment means that
Ginnies trade at a tighter spread than conventionals.
Banks typically need to own some Ginnies for their capital
treatment, and some overseas investors will not buy
conventionals.
Ginnie-guaranteed pools are either collateralized by loans from
a single issuer or by loans from multiple issuers (otherwise
known as a major pool) – Ginnie issues one major pool a
month per coupon.
AGENCY MBS PRIMER
Conventional
Price
Ginnie
Price
FNCL 3.0
95-09
G2SF 3.0
96-15
FNCL 3.5
98-03
G2SF 3.5
99-03
FNCL 4.0
100-22
G2SF 4.0
101-13
FNCL 4.5
102-29
G2SF 4.5
103-04
MORGAN STANLEY RESEARCH
48
Ginnies
FHA and VA mortgages
•
FHA and VA both have streamlined refinance programs that allow borrowers to easily refinance with minor closing costs
after six months, though they are required to show that they benefit from the refinancing (Net Tangible Benefit test)
•
VA mortgages require 0% down payment and FHA requires only ~3.5% down (although this may increase depending on
the borrower’s FICO). This leads them to have high LTV ratios (especially VA, where LTvs. may even be >100% since
borrowers may bundle closing costs into their loan).
•
–
In comparison, conventional mortgages require ~20% down payment to avoid paying LLPAs.
–
The smaller the down payment that is required, the more negatively convex a bond will be since borrowers are
more likely to both purchase and refi when they don’t need to come up with money for down payments.
Since FHA specifically services low-income borrowers, FHA mortgages tend to exhibit lower borrower credit quality
(higher DTI, lower FICO, etc.).
–
•
•
FHA accordingly experiences greater defaults and buyouts than VA or conventional mortgages, increasing
prepay speeds as a discount.
VA does not require mortgage insurance but FHA requires both upfront and annual mortgage insurance.
–
In comparison, conventionals require mortgage insurance if LTV > 80%.
–
Requiring mortgage insurance causes bonds to be less negatively convex as insurance is an additional financial
barrier to refinancing.
Note: Ginnie does not have LLPAs.
AGENCY MBS PRIMER
MORGAN STANLEY RESEARCH
49
Ginnies
Other characteristics
Lock-out
•
New developments
•
Ginnie Mae found that certain originators were
allegedly pushing veterans through unneeded
refinances, and temporarily restricted them from
delivering into Ginnie major pools.
If a lender refinances a Ginnie-guaranteed mortgage
before the borrower has had the mortgage for 6 months,
the lender may not deliver the refinanced loan into a
Ginnie major pool.
Loan balance
•
As lenders can sell a major-deliverable loan for more
than a non-deliverable one, the WALA ramp for Ginnieguaranteed loans spikes after 6-7 months as lenders
aggressively push borrowers to refi post-lock out.
•
While conventional loan balance pools pay faster
than TBA at a discount, Ginnie loan balance pools
pay slower than TBA at a discount (it is unclear why
Ginnie loan bal pools pay so slowly). These pools
are also not deliverable into tBA
CPR
60
CPR
25
50
40
20
30
15
20
10
10
5
0
1
2
3
4
5 6 7 8 9 10 11 12 13 14 15
Months Since Issuance
Conventional 4.5s
FHA 4.5s
VA 4.5s
Source: eMBS, Morgan Stanley Research
AGENCY MBS PRIMER
-1
-0.75 -0.5 -0.25
0
0.25
Incentive
0.5
0.75
1
Conv TBA
Conv LLB
Source: eMBS, Morgan Stanley Research
MORGAN STANLEY RESEARCH
50
Trades and Valuations
Common trades – basis
•
Mortgage investors express views on relative value through a few common trade structures in TBA:
•
Mortgage basis: An investor gets either long or short mortgages vs. a duration hedge, along with perhaps hedging out their
vol.
– The most common trade is the production coupon vs. ten-year notes or ten-year futures, but then curve exposure is
often hedged out later.
– Investors will have curve, convexity, and spread risk.
– Investors will have views on many aspects of the market to trade the basis, generally broken up into fundamental and
technical aspects:
– Fundamentals:
•
Is the OAS/ZV/other spread wide or tight to historical levels?
•
How does that spread compare to other risk assets (investment grade credit, commercial mortgage-backed spreads,
stock market, etc.)?
•
Do they think future interest rate volatility will be higher or lower than the market is currently implying?
•
Are prepays coming in higher or lower than the model says (or do they think prepay risk is picking up/coming down)?
– Technicals:
•
What does the supply and demand picture look like? Is there more supply now than historically?
•
What does the carry profile look like? Is it getting better or worse?
AGENCY MBS PRIMER
MORGAN STANLEY RESEARCH
51
Trades and Valuations
Common trades – coupon swap
•
Coupon swap: An investor can buy one coupon while selling another coupon against it, e.g., buying FNCL 4.5s and
selling FNCL 4s, if they believe the relationship between the two coupons is mispriced. They are typically done with
either the same notional, or close to duration-neutral.
– Adjacent coupon swaps (i.e., 4.5/4) are most common, but non-adjacent swaps also trade.
– Linguistically, to “buy” a swap is to buy the higher coupon and sell the lower coupon.
– Investors will typically buy coupon swaps if they think the market is pricing in too much prepay risk, and sell them if
the opposite.
– Investors will generally have rate and/or curve exposure when putting on a coupon swap.
– They will look at a time series of the OAS and ZV differences between the coupons, along with what the deliverable
is for each TBA to help value the swap.
AGENCY MBS PRIMER
MORGAN STANLEY RESEARCH
52
Trades and Valuations
Common trades – coupon swap
•
Coupon swap (continued): Investors will often look at relationships between the price of a trade (e.g., a coupon swap)
and metrics like the 10yr rate, curve, and the trade’s carry to help evaluate the trade’s relative valuation. However, it is
important to note that correlation does not imply causation, and caution should be used when inferring future
performance from regression analysis.
4/3.5
FNCL 4/3.5 vs. 10yr Rate*
2.9
2.7
2.5
2.3
4/3.5
3.1
FNCL 4/3.5 vs. 2s10s Curve*
4/3.5
3.1
2.9
2.9
2.7
2.7
2.5
2.5
2.3
2.3
2.1
2.1
2.1
1.9
1.9
1.9
1.7
1.7
1.7
1.5
1.5
1.5
-0.07
1.25
1.75
2.25
10yr Rate
2.75
0.70
0.90
1.10
2s10s Spread
1.30
*Data from Apr 2016 – Jun 2017
FNCL 3.5s have more duration than
FNCL 4.0s, and so a 4/3.5 swap on
even notional will have about -1 yrs
of duration – as rates move higher,
the swap’s value moves higher, too.
AGENCY MBS PRIMER
As the spread between the 2yr and
10yr rate increases, longer-duration
assets underperform, and FNCL 4s
should outperform FNCL 3.5s,
causing FNCL 4/3.5 swap to move
higher.
FNCL 4/3.5 vs. 4/3.5 Carry*
-0.02
0.03
4/3.5 Carry
Source: Morgan Stanley Research
As the carry on a trade increases,
investors will generally pay more for it.
Usually, higher coupons have higher
carry. However, back in the 2016-17
timeframe, the Fed was buying the
production coupon (3.5s), driving the roll
more special and increasing the 3.5’s
carry. This is why we see the 4/3.5 carry
as negative in some instances.
MORGAN STANLEY RESEARCH
53
Trades and Valuations
Common trades – butterfly
•
Butterfly (“fly”): An investor can also take a view on a coupon’s relationship to both adjacent coupons by putting on a
butterfly, or fly, trade.
– To buy a fly, an investor buys two parts of the middle coupon and sells one part each of the higher and lower coupons.
For example, an investor could buy 100mm of the “4 fly” by buying $100mm FNCL 4s, selling $50mm FNCL 3.5s, and
selling $50mm FNCL 4.5s.
– Typically, when an investor thinks a fly is cheap, they think the belly security (in this case, 4s) is cheap.
– Theoretically the price of the fly measures the negative convexity of the coupon. If interest rates rally 50bp, a FNCL 4
should look like a current 4.5, because the new FNCL 4 will have more prepay incentive at lower rates (like the current
4.5). Therefore, you can approximate the price of a FNCL 4 into a 50bp rally or 50bp sell-off by looking at the current
price of FN 4.5s and FN 3.5s, respectively.
•
A very negatively convex security will marginally appreciate in price into a rally but significantly decrease in price into
a sell-off. Consequently, the relative price of the FNCL 4.0 compared to the 3.5 and 4.5 can approximate the 4’s
convexity, and that difference is captured by the fly’s price.
•
You can also think of a fly as the difference between the 50bp coupon swap above and below (i.e., buying 4.0/3.5
swap and selling the 4.5/4 swap).
– Because of this, flies should typically be positive carry (since buying a fly is a negatively convex trade).
AGENCY MBS PRIMER
MORGAN STANLEY RESEARCH
54
Trades and Valuations
Common trades – butterfly
•
Butterfly (continued): Investors will sometimes construct multivariate regression that include a rate and carry aspect,
along with understanding the deliverable differences between coupons, in order to evaluate the relative value of the fly:
FNCL 4 Fly vs. 10yr Rate*
4 Fly
0.5
0.4
0.3
0.2
0.1
0.0
-0.1
-0.2
-0.3
-0.4
-0.5
1.00
1.50
2.00
2.50
10yr Rate
3.00
3.50
*Data from Apr 2016 – Sep 2018
The price of the fly should theoretically reflect the
coupon’s convexity. As 10yr rates sold off from 1.5%
to 3%, FNCL 4s became more negatively convex as
their price decreased towards $102 (generally the
most negatively convex coupon is priced around
$102, which we get into later). Therefore, the price of
the 4 fly increased as rates sold off – however, if
rates continued to sell off through 3%, FNCL 4s
would start to become less negatively convex as
their prices moves below par, and the relationship
between the 4 fly and 10yr rate could invert.
AGENCY MBS PRIMER
4 Fly
0.5
0.4
0.3
0.2
0.1
0.0
-0.1
-0.2
-0.3
-0.4
-0.5
-0.6
-0.15
FNCL 4 Fly vs. 4 Fly Carry*
-0.10
-0.05
0.00
0.05
0.10
4 Fly Carry
Source: Morgan Stanley Research
The carry of a FNCL 4 would be 2 * FNCL 4 carry –
(FNCL 4.5 carry + FNCL 3.5 carry). One thing to note
is that the 4 fly’s carry is a function not only of how
the FNCL 4 roll is trading but also of how the FNCL
4.5 and 3.5 rolls are trading, so there are many
inputs for an investor to monitor that could impact the
carry and potentially the price of the fly.
MORGAN STANLEY RESEARCH
55
Trades and Valuations
Common trades – G2/FN swaps
•
G2/FN swaps: An investor can buy a Ginnie security and sell a
Fannie security of the same coupon.
–
–
–
–
•
If they think the market is mispricing the difference between
Ginnies and Fannies (which we go into more later) they will
trade G2/FN swaps.
This is typically either done notionally neutral or durationneutral (trading less Fannies than Ginnies).
Because Ginnies are more negatively convex and prepay
faster, Ginnies have shorter duration than Fannies, and thus
G2/FN swaps will typically appreciate into a sell-off.
Investors will look at the price of the swaps as a function of
rates and carry, but changing legislative landscapes make
longer-term lookbacks difficult.
Box swaps: An investor can buy one G2/FN swap and sell
another G2/FN swap, which allows them to express a view on a
specific coupon/product’s relative value, as both coupon stack
and Agency exposure are “boxed in.”
–
If they bought the 4/3.5 box, they would buy 100mm G2/FN 4
and sell 100mm G2/FN 3.5 They would end up having no
net exposure to Ginnies or Fannies or 4s or 3.5s, but are just
expressing a view that G2/FN 4 would appreciate vs. G2/FN
3.5.
AGENCY MBS PRIMER
In general, Ginnies pay faster than Fannies and
therefore have shorter durations. The G2/FN swap
would have negative duration, so as 10yr rates sell
off, the price of the G2/FN swap should increase.
4 Fly
0.8
G2/FN 4 vs. 10yr Rate*
0.6
0.4
0.2
0.0
-0.2
-0.4
-0.6
2.00
2.20
2.40
2.60
2.80
10yr Rate
3.00
3.20
*Data from Jun 2017 – Sep 2018
4 Fly
0.8
G2/FN 4 vs. G2/FN 4 Carry*
0.6
0.4
0.2
0.0
-0.2
-0.4
-0.6
-0.15
-0.10
-0.05
G2/FN 4 Carry
0.00
0.05
Source: Morgan Stanley Research
MORGAN STANLEY RESEARCH
56
Specs
Specified pools
•
Mortgages with different characteristics exhibit different prepayment speeds, and investors will pay more for pools that
exhibit favorable characteristics.
–
These different characteristics are called “stories”.
–
Common stories include loan size (e.g., LLB and MLB), high LTV, low FICO, investor, geography (e.g., NY and
Puerto Rico).
–
Mortgage originators pool together mortgages with favorable prepayment characteristics and sell those pools to
investors at a “pay-up” to the TBA of the same coupon, which represents the price above the TBA for the pool.
•
–
•
For example, the pay-up for a FNCL 3.5 LLB is currently 20 ticks (see table). If the FNCL 3.5 is priced at 9803, the FNCL 3.5 LLB would be priced at 98-23.
Often, loans have overlapping characteristics (e.g., a low FICO loan that also has a high LTV) and the originator
must strategically decide which pool to bucket the loan into to maximize profits.
Specs trade in CUSIP form and
investors know all of the relevant
characteristics (i.e., WAC, WAM,
WALA, average loan size, and
prepayment history) when buying
them.
–
With TBA, these specific
characteristics are
unknown.
AGENCY MBS PRIMER
Loan Bal
TBA
Spec Pay-ups
LLB MLB
HLB
FNCL 3.5
0
20
15
10
FNCL 4.0
0
32
28
24
FNCL 4.5
0
59
50
40
FNCL 5.0
0
76
64
48
Pay-ups increase as loan balance
decrease, as prepayment protection is
greater for lower loan balances.
VHLB 200K NY
Pay-ups
5
7
4
increase as
coupon
15
18
12
increases since
higher coupons
38
29
18
have greater
prepay risk.
55
31
20
Source: Bloomberg, Morgan Stanley Research
MORGAN STANLEY RESEARCH
57
Specs
Valuations and trading characteristics
•
Different investors buy spec pools for different reasons, though most will run the pools through some model.
•
Theoretical % OAS is the percent of the theoretical pay-up (which is obtained by finding the price of the spec at
which the spec’s OAS = TBA’s OAS) that the spec pool is trading at, and is a useful metric to compare stories with.
•
•
•
•
However, investors will have different views on either the model or the TBA and are willing to pay up more than the
theoretical fair pay-up, driving theoretical % OAS ≥ 100%.
From this graph, we see that HLB 3.5s
have the best pay-up convexity, with payPay-up convexity measures how pay-ups could react to rate
ups showing little downside into a sell-off
changes based on pay-ups of adjacent coupons.
and a lot of upside into a rally.
•
Coupons with attractive pay-up convexity will have pay-ups
that should increase significantly more into a rally than
decrease into a sell-off. For example, if the pay-up of a MLB
4 is 10, the pay-up for a MLB 3.5 is 8, but the pay-up for an
MLB 4.5 is 25, the MLB 4 has attractive pay-up convexity,
as the MLB 4 should appreciate 15 ticks in a rally.
As long as the spec pool is deliverable into TBA, the pay-up is
floored at zero (most pools are deliverable save for Jumbos,
pools made up of modified or reperforming loans, and certain
other stories that don’t have a normal ticker).
This means that the profile of owning specs that have call
protection vs. being short TBA means that you can have high
profits into a rally with minimal loss into a sell-off. This is
similar to being long a call option on rates.
AGENCY MBS PRIMER
HLB 3.5
Source: Morgan Stanley Research
MORGAN STANLEY RESEARCH
58
Specs
Valuations and trading characteristics
•
Investors can hedge their duration exposure with mortgages, rates, and/or in vol space.
•
Investors will frequently hedge out duration with TBA, as getting short a more negatively convex assets makes the trade net long
convexity. Often, investors will hedge with a lower-coupon TBA, as the duration of loan bal 4.5s, for example, is more similar to
TBA 4s.
•
Investors looking to monetize a long convexity position (long spec/short TBA) can sell receiver swaptions (investors start long vol
and sell rate options until they are even vol again). This allows them to immediately take profit from the spec’s convexity
advantage.
Product
MLB 4.5s
OAS
Effective
Duration
Convexity
Pros
Cons
45
5.4
-1.0
-
-
38
4.2
-2.3
MLB 4.5s are deliverable into TBA (the
hedge) so the investor’s max loss is the
pay-up; net long convexity.
Curve risk
28
5.2
-2.0
Better duration/curve match, which reduces
need to re-hedge (reducing transaction
costs); selling tighter OAS bond.
Less positive convexity
exposure than higher coupon
TBA.
0
Depends
on tenor
Slightly
positive
Can match duration/curve exposure better
with partials across UST maturities.
Increased negative convexity
(now short positively convex
Treasuries).
0
Depends
Very
positive
Monetize positive convexity of long specs
vs. short TBA via explicitly selling option to
improve carry.
Less liquid; Exposed to ratemortgage vol basis.
TBA 4.5s
TBA 4.0s
Treasuries
Receiver
Swaption
AGENCY MBS PRIMER
MORGAN STANLEY RESEARCH
59
Specs
Valuations and trading characteristics
Pay-up Factor
Influence
Roll Specialness
When rolls are special, investors earn more being long TBA and pay-ups decline for specs.
Rates
When rates increase, prepayments slow down for TBAs, diminishing the prepayment advantage of specs and
reducing pay-ups.
Yield Curve Shape
When yield curve steepens, pay-ups decrease, as forward mortgage rates are higher and the call protection
will not last as long. Steep yield curves also increases hedging costs, making it more expensive to hedge extra
duration in specs.
TBA S-Curve
When TBAs exhibit flatter prepayment S-curves, the prepayment advantage and pay-ups of specs both
decline. Alternatively, when the TBA is more negatively convex, pay-ups increase.
Cost of Balance
Sheet
When balance sheet is more expensive, spec pay-ups go down as the cost to own pools vs. TBA increases.
CMO demand
When CMOs are getting issued, typically pay-ups go up, as CMO execution may be better than real money
demand.
Volatility
When vol is higher, investors can monetize the better convexity of their specs vs. TBAs more frequently, so the
pay-ups will typically increase.
TBA clarity
When it is easy to identify the worst to deliver, investors will pay more for specified pools as they will know what
to avoid.
AGENCY MBS PRIMER
MORGAN STANLEY RESEARCH
60
SECTION 4
CMOs, Agency CMBS, and Agency Debt
Collateralized Mortgage Obligations, Agency Commercial MBS, and Agency Debt
AGENCY MBS PRIMER
MORGAN STANLEY RESEARCH
61
Collateralized Mortgage Obligations
What are they?
•
Securitized products are a tool to transform risk. Frequently, the risk that is transformed is credit risk, such as in Collateralized
Loan Obligations (CLOs) and non-Agency MBS. However, we can also transform prepay risk through structuring in the Agency
MBS market.
•
Collateralized Mortgage Obligations (CMOs) are securities backed by MBS that redistribute the prepay risk of the underlying
pools into different tranches.
•
Investors can choose a tranche of the CMO to invest in based on their risk appetite, funding, and liabilities. They will pay a little
more to get exactly what they want, leaving other investors to buy the residual (perhaps at wider spreads).
–
Generically, the aggregation of the tranches characteristics (size, duration, convexity, OAS) should be roughly similar to the
pool’s, with the sizes having to aggregate correctly, but the OAS and price do not, for instance.
–
For example, banks that want a shorter duration profile may buy a CMO that is structured to pay off relatively quickly (front
sequential). If they want floating-rate exposure they may want a bond that is structured to pay a margin above Libor (floater).
If they like the collateral profile but want a lower dollar price, they could structure the security with a lower coupon (strip
down). If they want more certainty about their duration exposure, they would buy a Planned Amortization Class (PAC).
Mortgage
Mortgage
Mortgage
Mortgage
Mortgage
Agency MBS
Collateralized
Mortgage
Obligation
(CMO)
CMO Tranche A
CMO Tranche B
CMO Tranche C
Source: Morgan Stanley Research
AGENCY MBS PRIMER
MORGAN STANLEY RESEARCH
62
Collateralized Mortgage Obligations
Sequential structure
•
A sequential structure divides principal payments sequentially to create
tranches with varying durations. This allows investors to better target
their liabilities.
•
All active tranches receive interest payments, but the principal goes to
the first tranche until that is paid off, then sequentially after that until the
structure is fully paid off.
•
Different tranches of a sequential offer different duration exposures. The
duration of longer tranches will change more as prepay assumptions
change.
Principal
Interest
$mm
200
180
160
140
120
100
80
60
40
20
0
Front Seq - 100 PSA
0
50
150 200 250 300 350
Deal age
Source: Bloomberg, Morgan Stanley Research
$mm
Back Seq - 400 PSA
180
B
C
160
140
120
100
Time
B
C
80
60
40
20
0
C
AGENCY MBS PRIMER
100
Front Seq - 400 PSA
200
All principal
A
flows to
tranche A
first…
Once tranche A
is paid down,
interest stops
flowing to A and
all principal
starts flowing to
B
Back Seq - 100 PSA
0
50
100
150 200 250 300 350
Deal age
Source: Bloomberg, Morgan Stanley Research
MORGAN STANLEY RESEARCH
63
Collateralized Mortgage Obligations
PAC structure
•
A Planned Amortization Class (PAC) structure protects investors
against both call risk and extension risk between a set range of
prepay speeds.
$mm
250
PAC
Lower Band - 100 PSA
Upper Band - 250 PSA
200
•
For the sample structure shown here, the PAC principal
paydowns will follow an exact schedule if prepay speeds stay
between 100 PSA and 250 PSA.
–
–
–
–
•
A PAC schedule determines the amount of principal that is
paid down to the PAC bond if speeds stay within the PAC
bands. This is determined by taking the minimum of the
principal paydown schedule of the upper and lower bands.
In the beginning of the deal, any principal paydowns that
come faster than 100 PSA but under 250 PSA will be directed
to the support tranche.
Later on in the deal (past ~100 months), extra principal
paydowns (faster than 250 PSA but under 100 PSA) will also
accrue to the support tranche.
150
100
50
0
0
50
$mm
250
100
150
200
250
300
350
Deal age (months)
Source: Bloomberg, Morgan Stanley Research
PAC
Support at 150 PSA
200
150
100
The support tranche is very sensitive to changes in prepays,
and it is extremely negatively convex.
Banks and money managers both buy CMOs for targeted
duration exposure.
AGENCY MBS PRIMER
50
0
0
50
100
150
200
250
300
350
Deal age (months)
Source: Bloomberg, Morgan Stanley Research
MORGAN STANLEY RESEARCH
64
Collateralized Mortgage Obligations
PAC structure
•
$mm
300
Busted PAC at 315 PSA
If prepays come in faster than the upper band’s speed,
principal will accrete to the support tranche until it is fully paid 250
down.
Support at 315 PSA
Original PAC
200
–
•
If initial prepays are slower than the lower band’s speed, the
PAC’s duration immediately starts to extend.
–
•
Now without a support, subsequent early payments will
flow directly to the “busted” PAC, and the PAC’s duration
is now a function of interest rates.
150
100
50
0
However, if speeds increase in the future, principal
payments that come in ahead of schedule will go towards
paying down the PAC until it has been “caught up” and is $mm
300
back on schedule.
A PAC can also be busted despite rates staying between the
bands. The Whipsaw effect refers speeds “whipping” back
and forth above and below the bands, causing the PAC to
break (even if the average speed is within the bands).
0
50
100
150
200
250
300
350
Deal age
Source: Bloomberg, Morgan Stanley Research
Busted PAC at 50 PSA
Original PAC
250
200
150
100
•
As the PAC ages, the bands shift depending on how fast
prepays are. Faster initial prepays (within the bands) leave
less room for bond to extend, causing the lower band to
move higher.
AGENCY MBS PRIMER
50
0
0
50
100
150
200
250
300
350
Deal age
Source: Bloomberg, Morgan Stanley Research
MORGAN STANLEY RESEARCH
65
Collateralized Mortgage Obligations
Principal and interest
•
Another way to structure mortgage cash flows is splitting out principal and
interest payments, or an interest-only bond (IO) and principal-only bond
(PO).
•
This creates a very long mortgage CMO (PO) and one with negative
duration (IO). The IO is a leveraged bet on the prepays.
•
IOs have negative duration and negative convexity:
IO
PO
TBA
Duration
-
+
+
Convexity
-
+
-
Approx. Price
$15
$85
$100
– As interest rates decline and prepays increase, the total dollar amount of interest an investor will receive
decreases, causing the value of IO to decrease into a rally.
– Conversely, increased future interest payments cause the IO’s value to increase into a sell-off.
– As speeds pick up more into a rally then they decrease into a sell-off, as rates decline the bond’s value decreases
at an accelerating rate – i.e., it has negative convexity as well.
– Investors may find this profile attractive as it allows them to get short duration while having positive carry.
•
POs have positive duration and positive convexity due to a deeply discounted price:
– If rates rally, principal is returned earlier than expected, which is good for a discount bond. Similarly, if rates sell off,
principal is returned slower (positive duration).
– Unlike IO, PO benefits from the fact that speeds pick up more into a rally than decrease into a sell-off (positive
convexity).
AGENCY MBS PRIMER
MORGAN STANLEY RESEARCH
66
Collateralized Mortgage Obligations
Inverse IOs and floaters
•
•
A CMO structuring desk can also split a fixed-rate bond into a floater and
inverse IO.
Floaters have the principal from the deal, and pay Libor plus a small
spread (e.g., Libor+50bp) up to a fixed cap (e.g., 6.5%). They are
generally priced around par.
IIO
Floater
TBA
Duration
+
~0
+
Convexity
-
~0
-
Approx. Price
$15
$100
$115
– As long as the current rate is far away from the cap rate, floaters do not have much duration. As the Libor rises
and the current floating rate approaches the cap, floaters start to have a duration profile that is more similar to a
fixed-rate bond, since if Libor moves above the cap, the coupon would effectively be a fixed rate.
•
Inverse IOs (IIOs) pay the remaining interest from the deal (e.g., 6% - Libor) and are priced in the $10-$20 context.
IIOs are exposed to many risk factors:
– As Libor falls, the IIO investor receives more coupon. However, if rates decline and prepays generally increase,
the investor receives less interest overall.
– Therefore, IIO investors want the curve to steepen, and often hedge their IIO position with flatteners (buying
10yr rate and selling 2yr rate, for example).
– IO and IIO valuations are very model-driven, and derivative investors are often very knowledgeable about the
details of prepayment models as small changes to assumptions can have large impacts on valuations.
– Due to the model sensitivity, IO and IIO will often have an OAS of ~250.
AGENCY MBS PRIMER
MORGAN STANLEY RESEARCH
67
Collateralized Mortgage Obligations
Strip down
•
Often strip-downs are used to create synthetic coupons.
•
A common deal is to take a higher-coupon bond, such as FN 4.5s, and
create synthetic FN 3.5s and FN 5.5s off the 4.5 collateral. These deals
have many moving parts:
Cpn: 4.5% on $100mm
P: $100mm
Px: $103
– The CMO desk will model out the potential structure, which could
look like:
•
$100mm FN 4.5s are split into $50mm FN 3.5s and $50mm FN
5.5s.
•
The synthetic 5.5s are then split into a floater and IIO:
Strip
down
Cpn: 3.5%
on $50mm
P: $50mm
Px: $99
Cpn: 5.5%
on $50mm
P: $50mm
Px: $107
IIO
Cpn:
5.1%-L on
$50mm
P: $0mm
Px: $20
Cpn:
L+0.4% on
$50mm
P: $50mm
Px: $87
– The floater has the principal, pays Libor+40bp, and is priced
near par.
– The IIO pays the remaining interest (5.1%-Libor) from the
synthetic FN 5.5s.
– The deal will only be created if it is economically viable. If the
strip-down FN 3.5 has a relatively high price, the deal might
still make money despite the IIO having a worse price, or vice
versa.
•
Floater
The CMO desk has to coordinate with the deriv desk as well as
the flow desk to track the price of the FN 4.5 collateral.
AGENCY MBS PRIMER
MORGAN STANLEY RESEARCH
68
Agency CMBS
Guaranteed multi-family securities
•
The GSEs and the US government guarantee multi-family properties
in addition to single-family residences.
•
The Agency CMBS market is over $600bn in size and has been
growing rapidly since the financial crisis.
•
Unlike Agency MBS, Agency CMBS features call protection for most
of the life of a bond, meaning prepay risk to the investor is low.
– Agency CMBS investors primarily face spread risk and liquidity
risk, and take little credit or prepay risk.
•
The most common Agency CMBS structure is a fixed-rate, 10yr bond
with 9.5 years of call protection.
•
Given longer WAL and less convexity, Agency CMBS is often
compared to low-coupon single-family mortgages as well as bullet
debentures.
•
Agency CMBS is quoted to the swap curve, as opposed to singlefamily Agency MBS which is generally quoted to Treasuries.
CMBS Outstanding Universe
FNMA
Megas /
ACE's,
$62bn
GNR,
$101bn
Conduit,
$347bn
FNMA
DUS,
$216bn
FREMF &
SB,
$232bn
SASB,
$135bn
Large
Loan,
$22bn
Source: SIFMA, eMBS, Morgan Stanley Research
Spread (S+bp)
250
110
230
100
210
90
190
80
170
70
150
60
130
50
110
40
90
30
70
50
20
04/15 11/15 06/16 01/17 08/17 03/18
CMBS AAA
Corp IG
Freddie A2 (right)
FNCL 3 L ZV (right)
Source: YieldBook, Bloomberg, CMA, Morgan Stanley Research
AGENCY MBS PRIMER
MORGAN STANLEY RESEARCH
69
Agency CMBS
Fannie DUS
•
Fannie’s DUS (Delegated Underwriting Service) program allows a group of approved lenders to issue multi-family
property loans and have the principal and interest guaranteed by Fannie Mae without prior approval as long as they
follow specific guidelines.
– Hundreds of guaranteed DUS pools (usually backed by single loans) are issued each month.
•
While DUS pools trade individually in the secondary market, they can also be pooled into DUS Megas which are large
pass-throughs, or be structured into DUS REMICS (known as Aces) which have different tranches (i.e., sequentials, IOs,
and floaters – just like CMOs).
•
Fannie offers prepayment protection to the investor in the form of yield maintenance. If a borrower voluntarily prepays
(i.e., excluding defaults), the borrower must pay a yield maintenance fee to the investor to compensate them for the lost
future interest.
– This fee increases as rates rally below the current note rate, reflecting the greater negative impact of prepays on the
investor at lower rate levels due to reinvestment risk.
– Yield maintenance fees are not guaranteed, so in the event of a default, the investor immediately gets their principal
back at par but is not compensated for lost future interest.
– The typical loan structure, “10/9.5”, is a 10-year balloon loan with prepayment protection via yield maintenance for 9.5
years.
•
The pricing convention for DUS is 0% CPY (zero default throughout life and no prepayment after the yield maintenance
period ends).
AGENCY MBS PRIMER
MORGAN STANLEY RESEARCH
70
Agency CMBS
Freddie K
•
Freddie’s K-Series program issues several large deals per month backed by roughly 30-90 multifamily loans.
– These deals can be primarily fixed or floating rate and have both guaranteed and unguaranteed tranches.
– For example, a benchmark K-series deal could have a large guaranteed A2 tranche (usually structured as a
10/9.5), a smaller guaranteed senior A1 tranche, unguaranteed mezzanine tranche(s), and IO strips.
– Investors often compare Freddie K A2 10/9.5 tranches with Fannie DUS 10/9.5 pools. Due to a larger deal size,
A2s have greater liquidity than smaller DUS pools, and generally trade at a slight premium.
– Like Fannie DUS, the pricing convention for Freddie Ks is 0% CPY.
•
Freddie handles defaults differently than Fannie. If a
Fannie DUS loan defaults, investors get their money
back at par immediately and without yield maintenance
fees. Freddie, however, does not guarantee the
timeliness of principal payments, so an investor could get
their money back either as soon as the defaulted
property is liquidated or at the very end of the loan term.
AGENCY MBS PRIMER
Class A1
AAA - Guaranteed
$150mn (15%)
Mortgage Pool
70 loans
$1Bn (100%)
Class A2
AAA - Guaranteed
$750mn (75%)
Class B
A
$60mn (6%)
Class C
Unrated
$40mn (4%)
Class X3
– To the investor, their cash flow looks identical. In fact,
defeasance enhances the quality of the security by
swapping in Treasuries which are technically a safer
asset than Freddie-guaranteed loans.
Interest Only
Classes
Class X2
Freddie primarily offers call protection through
defeasance, which is where a borrower who voluntarily
prepays must replicate the lost cash flow from future
interest payments, usually with a basket of Treasuries.
Sequential Pay
Classes
Class X1
•
Collateral
Source: Morgan Stanley Research
MORGAN STANLEY RESEARCH
71
Agency CMBS
Ginnie Mae Project Loans & GNR REMICs
•
Ginnie Mae project loans are issued for a wide range of programs, including low- and moderate-income multifamily housing,
nursing homes, hospitals and healthcare centers, rural development, and more.
•
Project loans are originated by private lenders approved by Housing and Urban Development (HUD), according to FHA rules.
•
A single project loan can be traded as a standalone certificate - as either a construction project loan (CLC) or a permanent project
loan (PLC). However, the majority of project loans are pooled and securitized into multiple-loan REMIC form (a GNR REMIC deal).
•
Project loans have dual insurance from FHA and Ginnie Mae, which together explicitly guarantee the full recovery and timeliness
of all cash flows when any of the project loans default.
–
•
Bank regulators attach a zero-percent risk weighting to project loans and GNR REMIC bonds similar to single family Ginnies.
Project loans can offer call protection through a prepayment premium option period, where the borrower can prepay if they pay a
premium based on the percentage of the current unpaid principal balance. This percentage declines over time according to a
specified schedule. Project loans used to have 2yr hard lockout period, but no longer.
–
The most common call provision now is a “0/10”: no lockout followed by an ten-year penalty that starts at 10% and declines by
1% each year.
•
Around 40 to 100 project loans, mostly 35- to 40-year fully amortizing mortgages, make up a GNR REMIC deal.
•
GNR REMICs are time-tranched similarly to a single-family CMO.
•
The pricing convention for GNR REMICs is 15% CPJ, which is a combination of Project Loan Default curve and a flat 15% CPR for
voluntary prepayments after the lockout period ends.
AGENCY MBS PRIMER
MORGAN STANLEY RESEARCH
72
Agency Debt
Agency debentures
•
•
•
•
Agencies issue four kinds of debt, known as “agency debentures”:
–
Discount notes: Short-term paper, issued at a discount to par, that matures in a 1 year or less.
–
Bullets: Conventional fixed-rate coupon-paying bonds.
–
Callables: Bonds that are both called and issued at par. Usually structured as Bermudan (callable on multiple
specific dates) or continuously callable bonds after a lockout period.
–
Floaters: Bonds with interest payments that are reset periodically (typically one month) and offer a spread above
some benchmark (usually 1mo Libor).
The largest issuers of agency debt are the Federal Home Loan Bank (FHLB), Federal Farm Credit Banks (FFCB), and
Freddie Mac and Fannie Mae (not explicitly guaranteed).
Total Outstanding Debt Balance by Product
$B
While the outstanding amounts of most types of agency
2500
debt have decreased modestly over time, floaters have
substantially increased in outstanding balance.
2000
FHLB currently accounts for over half of the total
outstanding Agency debt.
1500
1000
500
Bullets
Discount Notes
Floaters
Jul-18
Apr-18
Jan-18
Oct-17
Jul-17
Apr-17
Jan-17
Oct-16
Jul-16
Apr-16
Jan-16
Oct-15
Jul-15
0
Apr-15
In contrast, Fannie and Freddie have been
reducing their outstanding balance steadily,
slashing it by about half since 2015.
Jan-15
–
Callables
Source: Fannie Mae, Freddie Mac, FHLB, FFCB, Morgan Stanley Research
AGENCY MBS PRIMER
MORGAN STANLEY RESEARCH
73
Agency Debt
Agency debentures
•
Discount notes are the most heavily issued agency debt product by far, and significantly more floaters have been
issued over the past few years (FHLB issues 86% and 90% of discount notes and floaters, respectively).
•
Money managers, central banks, banks, and corporates/insurance represent the largest investors in the agency debt.
•
Some investors use agency debt as cash surrogates; money managers invest in agency debt to match the index on
which their performance is measured (Bloomberg-Barclays US Aggregate Bond Index).
Investor Breakdown for Total Outstanding Debt for
Fannie and Freddie
Total Gross Debt Issuance by Product for Top Agencies
$B
$B
900
800
700
600
500
400
300
200
100
0
120
100
80
60
40
20
Bullets
Floaters
Callables
Jul-18
Apr-18
Jan-18
Oct-17
Jul-17
Apr-17
Jan-17
Oct-16
Jul-16
Apr-16
Jan-16
Oct-15
Jul-15
Apr-15
Jan-15
0
Retail/
Other
2%
Govt
7%
Banks
14%
Corps/
Insur
12%
Central
Banks
18%
Money
Managers
47%
Discount Notes (RHS)
Source: Fannie Mae, Freddie Mac, FHLB, FFCB, Morgan Stanley Research
Source: Fannie Mae, Freddie Mac, Morgan Stanley Research
AGENCY MBS PRIMER
MORGAN STANLEY RESEARCH
74
Mortgage Backed Securities (MBS) and Collateralized Mortgage Obligations (CMO)
Principal is returned on a monthly basis over the life of the security. Principal prepayment can significantly affect the monthly income stream and the
maturity of any type of MBS, including standard MBS, CMOs and Lottery Bonds. Yields and average lives are estimated based on prepayment
assumptions and are subject to change based on actual prepayment of the mortgages in the underlying pools. The level of predictability of an
MBS/CMO's average life, and its market price, depends on the type of MBS/CMO class purchased and interest rate movements. In general, as
interest rates fall, prepayment speeds are likely to increase, thus shortening the MBS/CMO's average life and likely causing its market price to rise.
Conversely, as interest rates rise, prepayment speeds are likely to decrease, thus lengthening average life and likely causing the MBS/CMO's market
price to fall. Some MBS/CMOs may have “original issue discount” (OID). OID occurs if the MBS/CMO’s original issue price is below its stated
redemption price at maturity, and results in “imputed interest” that must be reported annually for tax purposes, resulting in a tax liability even though
interest was not received. Investors are urged to consult their tax advisors for more information. Government agency backing applies only to the face
value of the CMO and not to any premium paid.
AGENCY MBS PRIMER
MORGAN STANLEY RESEARCH
75
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Morgan Stanley uses a relative rating system using terms such as Overweight, Equal-weight, Not-Rated or Underweight (see definitions below). Morgan Stanley does not assign ratings of
Buy, Hold or Sell to the stocks we cover. Overweight, Equal-weight, Not-Rated and Underweight are not the equivalent of buy, hold and sell. Investors should carefully read the definitions of
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AGENCY MBS PRIMER
MORGAN STANLEY RESEARCH
76
Disclosure Section (Cont.)
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(as of September 30, 2018)
The Stock Ratings described below apply to Morgan Stanley's Fundamental Equity Research and do not apply to Debt Research produced by the Firm.
For disclosure purposes only (in accordance with NASD and NYSE requirements), we include the category headings of Buy, Hold, and Sell alongside our ratings of Overweight, Equalweight, Not-Rated and Underweight. Morgan Stanley does not assign ratings of Buy, Hold or Sell to the stocks we cover. Overweight, Equal-weight, Not-Rated and Underweight are not the
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Coverage Universe
Stock Rating Category
Overweight/Buy
Equal-weight/Hold
Not-Rated/Hold
Underweight/Sell
Total
Count
1178
1378
49
554
3,159
% of
Total
37%
44%
2%
18%
Investment Banking Clients (IBC)
Count
308
343
5
83
739
% of
Total IBC
% of Rating
Category
42%
46%
1%
11%
26%
25%
10%
15%
Other Material Investment
Services Clients (MISC)
% of Total
Count Other MISC
562
625
7
224
1418
40%
44%
0%
16%
Data include common stock and ADRs currently assigned ratings. Investment Banking Clients are companies from whom Morgan Stanley received investment banking compensation in the
last 12 months. Due to rounding off of decimals, the percentages provided in the "% of total" column may not add up to exactly 100 percent.
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12-18 months.
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next 12-18 months.
Unless otherwise specified, the time frame for price targets included in Morgan Stanley Research is 12 to 18 months.
Analyst Industry Views
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indicated below.
In-Line (I): The analyst expects the performance of his or her industry coverage universe over the next 12-18 months to be in line with the relevant broad market benchmark, as indicated
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Benchmarks for each region are as follows: North America - S&P 500; Latin America - relevant MSCI country index or MSCI Latin America Index; Europe - MSCI Europe; Japan - TOPIX;
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AGENCY MBS PRIMER
MORGAN STANLEY RESEARCH
77
Disclosure Section (Cont.)
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