It has been three months since the new GNMA II program took effect and analysts are starting to look at relative value comparisons to GNMA Is. Both JPMorgan Securities and UBS released recent studies on the subject.

Under the GNMA II program, originators must now pool mortgages with gross WACs 25 to 75 basis points more than the coupon rate. The old rules required that gross WACs be 50 to 150 basis points above the net coupon rate.

The change has resulted in an increasing supply of low WAC GNMA IIs. In most cases, WACs on these securities that were issued under the new rules are comparatively lower than their GNMA I counterparts.

Meanwhile, UBS explained that under the new program, all pools that are good delivery for TBAs will be large, diversified multi-issuer pools. In effect, a large, multi-issuer pool is created for each coupon every month. Although smaller, custom, single-issuer GNMA II pools are made each month, most of the issuance is in the large pool. Aside from this, the custom pools are not good delivery into TBA.

GNMA II pools are considered easier than GNMA I pools operationally speaking, said UBS. This is because investors receive only one check for all GNMA II certificates, compared to receiving one for each security held under the GNMA I program. Investors are also assured that they will get a piece of a large diversified pool, as only the large pools are considered good TBA delivery.

Additionally, under the GNMA I program, an investor can be delivered a small single-issuer program that does not reflect prepayments of the cohort. Further, it is easier to specify one pool under the GNMA II program, as the only deliverable pools are considerably large. There is also no extra charge for the large pool under GNMA II, which is often the case under the GNMA I program.

Relative value

There is no adverse prepayment dispersion on GNMA IIs compared to GNMA Is. Aside from the WAC, there are fundamental advantages of GNMA IIs versus GNMA Is. JPMorgan stated that since there is only one pool of GNMA IIs per coupon per month, the adverse prepayment dispersion on GNMA IIs is considerably lower versus GNMA Is. Adverse selection within GNMA IIs is restricted to prepayment diversion by WALA. On the other hand, in GNMA Is, adverse selection could be real.

Despite the fact that the recent prepayments on GNMA IIs were still higher than the GNMA I cohorts, the data on GNMA IIs still primarily shows loans that were securitized before the new program took effect, said JPMorgan. This is why the WACs on currently outstanding GNMA IIs are roughly 25 basis points higher than GNMA Is. Under the new program, GNMA IIs are probably going to have WACs that are roughly 10 basis points less than in GNMA Is, said analysts.

Considering the fundamental cheapness of the GNMA II sector versus GNMA Is, a greater percentage of GNMA IIs is used to back CMOs. This is why JPMorgan said that over the course of the last year, 69% of all GNMA II passthroughs have been "REMICed." That is to be compared with only roughly 19% of GNMA Is. Given the better execution on GNMA IIs, the share of GNMA II issuance as a percentage of all GNMA issuance is increasing and might reach up to 50% in four to six months.

There are better rolls in GNMA IIs. According to JPMorgan, the better technicals in GNMA IIs is reflected in a 1 to 1.5 tick advantage in the rolls versus GNMA Is. Analysts expect GNMA IIs to still outperform as the program gains traction. If pricing merely the longer delay of GNMA IIs, then GNMA II 5.5s and 6s would, respectively, appear 2.5 and 6.5 ticks cheap relative to GNMA Is. However, analysts expect that lower prepayment dispersion in GNMA IIs might add sufficient value to push the swaps to an even dollar, particularly if rolls stay firmer.

In the meantime, UBS believes that GNMA IIs are cheap relative to GNMA I counterparts, specifically in the 5.0% and 6.0% coupons. In the 5.0% coupon, for instance, UBS said that new GNMA IIs will be delivered into TBA. GNMA IIs are selling 10 ticks behind GNMA Is. With GNMA IIs paying on the 20th of the month compared to GNMA Is paying on the 15th, this delay is worth 2 ticks. "Thus, the GNMA IIs are economically 8 ticks cheap to the GNMA Is," wrote UBS. "You are getting essentially the same mortgage, but at a price 8 ticks cheaper."

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