With extension risk now at the forefront, interest in call protection from specified pools has diminished slightly, said JPMorgan Securities in a recent report, concluding that different specified pools offer varying degrees of extension protection.
The report examined characteristics such as loan balance, loan purpose, occupancy status, LTV and FICO, which comprise the list of the new GSE disclosures.
Low loan balance (LLB) pools seem to offer the most consistent extension protection (for a fixed WALA). Low FICO pools also seemed to provide some extension protection. But pools with a high refinancing share and a lot of investor properties only offered extension protection for modest refinancing disincentives.
The report examined the prepayment behavior of out-of-the-money specified pools in 2000. Though it is comparatively easy to do the analysis for low loan balance, there is really no historical data for the new GSE disclosures. The analysis assumed that current characteristics could be applied to the historical pools. This analysis also tended to underestimate the value of extension as many of the pools that now have low loan balances, low FICOs, and high LTVs may have had more TBA-like characteristics in 2000.
The GSE disclosures are actually meant for loans at origination, and the current differences are a result of divergent prepayment characteristics of the underlying loans. Still, this analysis offers useful information on the expected prepayment behavior of certain specified pools in a high rate scenario, wrote analysts.
JPMorgan said that low loan balance loans offer consistent extension protection. The firm stated that the convexity advantage of the LLB pools seems substantial for par-priced securities. Meanwhile, the main advantage of low credit scores is that they offer extension protection for deep discounts. These pools displayed no lock-in, which could be worth a substantial pay-up in a curve steepening scenario, wrote analysts. A pool with average FICOs below 675 also seems to offer incremental extension protection. This may be because of credit curing.
The report stated that pools with a high share of investor properties - above 20%- seemed to offer much less extension protection. They prepaid faster for slight disincentives, but the difference was only 4 CPR faster than the cohort. However, for deep out-of-the-money pools, they offered no protection. Pools with a high share of investor properties displayed considerable lock-in. JPMorgan said the pay-ups for these pools should be significantly lower compared to those for low loan balance or low FICO pools.
Pools with a high share of refinancings at origination offered extension protection only for modest disincentives, said analysts. The behavior of these pools as discounts seemed like those of pools with a high share of investor properties. In other words, they display considerable lock-in but have a higher base case turnover. Thus, these pools do not really offer a convexity advantage but have higher carry at slight discounts. At par and at modest discounts, there may be pay-ups for pools with a high refinancing share at origination. JPMorgan said that these pools should trade with a shorter duration (due to the higher base case speeds) but exhibit worse convexity than the cohort. As premiums they are TBA.
High LTV pools (over 85%) seem to provide no extension protection even with a strong housing market. Analysts might have expected that de-levering in the high LTV pools would have resulted in increased turnover, but this was not seen in 2000. But low LTV pools (under 70%) did offer some slight benefit when deep-out-of- the-money. In general, analysts said specifying LTV is of little value for discount securities. High LTV pools appear to have longer durations than the cohorts and only merit pay-ups as high premiums.
Specified pool pay-ups
Specified pool pay-ups have declined dramatically, specifically in 5.5s, said a report by UBS Warburg. Buysiders could currently get moderate protection at a minimal pay-up. Further, dollar rolls are not special in this coupon. The firm suggested taking advantage of low pay-ups on specified pools 5.5s.
In a Bear Stearns report, analysts said that the combination of lower dollar prices, slowing prepayment speeds as well as a less negatively convex MBS market would be putting pressure on specified pool pay-ups in the near term. For instance, despite the fact that low WALA, low WAC and high LTV lessen call risk, the very same characteristics actually also increase extension risk in a selloff scenario. Thus, Bear said that paying up for these characteristics might not be a good solution considering the expectation of a universal drop in prepayment speeds over a six-month horizon. There is also the likelihood of further erosion in pay-ups going forward. The firm added that low-FICO, alternative-A and "rate premium" collateral types the mitigate extension would probably fair better in higher rate environment. Low loan balance pools are neutral in terms of extension and are still providing investors with great call protection.
Other analysts said that if you look at specified pools prepaying at 6 CPR relative to a pool that is prepaying at 8 CPR, the former is a significantly shorter security. In that case, it is only a question of what the spread to the curve is, and the spread to curve on that longer duration could mean fairly hefty pay-ups. Looking at where these securities traded in late 1999 to early 2000, the pay-ups for these pools were considerably high then.
Furthermore, since there are not many new 5.5s being originated, the convexity of that roll has definitely gotten worse, causing pay-ups on these pools to come down. For those who believe that pay-ups in 30-year 5.5s are coming down, now is a good time to add specified pools in their portfolios, analysts said.
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