The TBA market is widely viewed as an essential element of a functioning mortgage market, serving as both the ultimate source of liquidity and a crucial pricing benchmark for housing finance. However, the market has evolved significantly over the last few years; a major change has been the growth of the specified pool sector. This column will examine this development and its implications for the MBS and mortgage markets.
Specified pools are those that trade away from the TBA market. Specified pool trading is more than 25 years old; the creation of new-origination specified pools, in which originators segregate and sell prepayment-advantaged loans separately from their generic production, began in the late 1990s, as analysts identified loan characteristics that resulted in consistently different prepayment behavior. However, the share of MBS issued and traded away from the TBA market has exploded over the past few years, to the point that 40% or more of the MBS market now trades as specified pools of some sort.
Specified pools can be broadly categorized by whether or not they are "deliverable" into TBAs. Some loan products (e.g., loans with LTV ratios greater than 105%) cannot be allocated into TBAs under SIFMA rules. Therefore, they can theoretically trade at a concession to TBAs, as Jumbo-conforming pools currently do. By contrast, deliverable pools should never trade through TBAs, since they can simply be allocated into TBA trades if market conditions change and their behavior is viewed as unfavorable. (For example, slow pools at a discount are not viewed as desirable.)
The growth of the specified pool market reflects the convergence of the interests of lenders and investors. Pay-ups for favorable loan characteristics have increased to all-time highs, rewarding originators savvy enough to increase revenues by optimizing their pipeline sales. Defined markets have developed for a variety of loan and borrower attributes. These include pools backed by loans with maximum loan balances (stratified from $85K to $175K balances); loans with high LTVs (e.g., 80%-90%, 90%-95%, etc.); and characteristics such as low-FICO and investor-property loans. (In many coupons, there is also a pay-up for brand-new pools, since they don't exhibit voluntary prepayments for a number of months after issuance.)
With the weighted-average price of 30-year FNMAs approaching 107, prepayment protection is an enormous concern for investors. Along with increased yields, slower prepayments have a significant impact on a position's net carry. Using the dollar roll market as a proxy, Fannie 4s are carrying at around 6/32s a month. Holding the funding cost constant, every 5% lower CPR is equivalent to a monthly pickup of 1/32 in carry. The accumulated carry advantage over time for slow-prepaying pools at current prices accounts for why payups for many attributes are at historically high levels. (For example, $85K-max Fannie 4.5s currently trade around three points over TBAs.) It's important to remember that the growth of specified pool trading and the current outsized pay-ups are largely a function of current dollar prices; when bond prices move lower, both specified pool pay-ups and the share of MBS traded as specified pools will drop.
Despite the scale of non-TBA trading, however, the TBA markets remain a critical source of liquidity to the mortgage market, as well as an essential pricing benchmark for lenders. Initiatives such as proposals to change servicing to a fee-for-service arrangement risk disrupting the TBA market and make comparisons across cohorts and vintages extremely difficult. The dismal prospects for a recovery of the private-label MBS market means that any attempt to restructure the GSEs must explicitly recognize and account for the essential role of the TBA market in housing finance.
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.
