The mortgage and MBS market landscapes have profoundly changed over the last month as a result of actions by both regulators and monetary authorities. While the more visible changes have resulted from the Fed's QE3 commitment to buy huge amounts of agency MBS, the less-discussed change in GSE guaranty fees has also impacted the consumer mortgage market and MBS issuance.
In addition to exerting upward pressure on mortgage rates, the mandated increase in guaranty fees has already impacted the conventional mortgage market by changing how loans are pooled into TBA-eligible Fannie and Freddie MBS. This discussion requires a brief review of pooling economics. Mortgage bankers have the option of pooling loans into different MBS coupons; absent other considerations, the originator will pool into the coupon that provides the greatest proceeds. The major variables are 1) the market prices of the two coupons, 2) the value that the originator places on "excess servicing" (i.e., servicing in excess of the 25 basis points of required servicing, 3) the amount of the guaranty fee, and 4) the price (or, more accurately, the multiple) at which the GSE will allow the originator to monetize (or "buy down") the guaranty fee.
Rising guaranty fees are having a profound impact on pooling execution. As an example, a loan with a 3.875% note rate can be pooled into either a conventional 3.5% or 3% pool. Assuming that the loan's g-fee is 25 basis points and the GSEs' buy-down multiples are 7x, best execution normally suggests that the lender will pool into a 3.5% coupon by 1) holding 25 basis points of required servicing and 2) buying down 12.5 basis points of g-fee at a 7x multiple for a cost of 0.875. (Holding 25 basis points of servicing and paying 12.5 bps of the 25 basis point g-fee from the loan's interest reduces the remaining interest rate to the 3.5% coupon.) If the guaranty fee is increased to 35 basis points, however, an additional 10 basis points must be bought down at the same 7x multiple. The extra 0.70 in cost changes the optimal execution from a 3.5% coupon into a 3% security; at the lower coupon, none of the g-fee needs to be bought down. (However, the originator must now either hold 27.5 basis points in excess servicing or sell it to the GSE at a quoted "buy-up" multiple, currently around 3x.)
Primarily because of the very high (~7x) multiples charged for g-fee buy-downs, the recent increase in g-fees has incented originators to "pool down" many loans into lower coupons. This means that Fannie and Freddie TBAs are being backed by loans with increasingly high note rates, which will have the effect of pushing coupons' gross WACs higher (or, put differently, widening the spread between pools' WAC and coupon rates). All things equal, this "WAC drift" means that pools originated late in 2012 and beyond will have higher GWACs and will thus prepay faster, making investors increasingly sensitive to WAC as a pool metric.
This phenomenon will in turn impact MBS trading. As a result of rising GWACs, I expect a market for low-WAC or maximum-note-rate specified pools to develop. These will trade in the same fashion as low-balance, high-LTV and other prepayment-advantaged pools.
Finally, the GSEs must stop distorting the MBS markets through their buy-down pricing. There is no justification for charging originators a 7x multiple to buy down g-fees while paying a 3x multiple for servicing, which is essentially the same cash flow. Since this is almost certainly not the last increase in g-fees, the GSEs should cease using their immense pricing powers and bring their buy-down pricing in line with market levels.
Bill Berliner is Executive Vice President of Manhattan Capital Markets. He is the co-author, with Frank Fabozzi and Anand Bhattacharya, of the recently- released second edition of Mortgage-Backed Securities: Products, Structuring, and Analytical Techniques. His email address is bill_berliner@manhattancapitalmarkets.com.
