Thursday 9/4 ... A question and an answer on 5.5's vs. 6.0's

Strap in for another one of those verbose posts. (understatement).

To some of you, this might not be required reading. To some, a good sleeping pill. To others, and I'm speaking of those of us who can't wait to greedily digest every piece of MBS and capital market related data we come across (aka "chasing the MBS dragon"), this will either be a great primer on the factors influencing what the market considers to be "current coupon," (aka "CC" as you may sometimes see on the "at a glance" post in the morning), or it will serve as some serviceable spackle to patch any holes in the wall of your MBS understanding. Whatever the case, the following was an answer I gave a friend in response to the question: "why would we look at 5.5's as opposed to 6.0's if we're still originating our loans in the low to mid 6 range?"

It's a great question, and hopefully this answer does it justice... Away we go!

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As you may or may not remember from blog posts past, we keep in contact with our team of MBS-ninjas on "the street" in order to get information that is not accessible through any other channel.
One of the things that's very important for us, and for traders, and indeed for the capital markets in general , is "which coupon is trading with the highest liquidity."
Granted, lenders are going to be executing a majority of their transactions going out the door securitized as 6.0 coupons, BUT, since the 5.5's are carrying a SIGNIFICANTLY higher amount of trade volume AND almost equally importantly, since the current bid momentum is DOWN IN COUPON, they (meaning 5.5's) are a better indication of OVERALL sentiment/demand/direction/momentum/"buying interest" for the entire FNMA 30 YR MBS stack. In other words, if someone is simply going to say "rates are going up!" or "Rates are going down!" they would probably be better served by focusing on the coupon stack that is seeing the most action. (stack can refer to either the entire range of a particular agency's available coupons and delivery dates, such as "the 30 year stack," and to a lesser extent, some traders, and myself also use stack to refer to a subsection of the bigger picture, such as "the 5.5 stack," which would refer to the different delivery dates and dollar rolls for the 5.5 MBS – currently sep, oct, nov, and then the "rolls" between those months.)
If the 5.5's are seeing a higher majority of trade units and dollar volume (liquidity), they will give us the best indication of what the major dealers (Chase being one) are paying for these MBS. The more trades that occur, and the higher the dollar volume of those trades, the more accurately we can rely on the overall "sentiment" of the bid (buy-side) demand. Since we have the obvious "down in coupon" move (notice that the higher end of the stack is much more poorly bid than the lower end of the stack), 5.5's are our new flagship.
Casting aside ALL of the aforementioned, there is one other significant factor: If we are moving down in coupon, that's one thing, but it's another thing altogether for the dollar price of a particular MBS to be obviously "closest to PAR." This would describe the 5.5's as of yesterday afternoon and now obviously today. Let's take a look as of this very moment (may change a bit by the time you read this). Ok, so using roughly 1:45PM EDT as our moment in time, 5.5's are at 99-23 bid price for a September delivery. Looking at the 6.0, we see the dollar price at 101-22+.
The REASON this is important, EVEN THOUGH YOU'VE JUST LIKELY ORIGINATED A MAJORITY OF LOANS IN THE 6-6.5 range, is the TBA component of MBS. TBA = to be announced = an executed trade is a COMMITMENT to deliver, but not the actual delivery of a pool itself. The loans that compose the pool are yet to be announced, hence TBA. The important part of this is that the current trading is for a delivery date that has not yet occurred. So DIRECTION becomes more important than the actual rate of the closed loans.
ALSO! It would be very uncommon in Agency coupons, for a WAC (weighted average coupon AKA average interest rate per dollar for any given securitized pool) to be EXACTLY 6.0 or 5.5 or 6.5 or whatever. So, for instance, if we have a WAC of 5.786736759 (or whatever decimal the trade screen cuts off at), the "originator" can sell the pool based on a yield calculation of a 5.5 or a 6.0. In other words, the WAC will pay more if you securitize it with a higher coupon in terms of dollar price, just as it might cost discount points if securitized with a lower coupon. But the varying yields offset the dollar price, and the whole mess is plugged into a calculation, in conjunction with historical data on prepayment speeds and default risk in order to determine the actual YIELD (not the same as coupon rate). That yield, factoring in the embedded "call option" that a mortgagor has to payoff, refi, sell, be foreclosed on, etc… , aka the REAL yield, is considered in deriving OAS (option adjusted spread).
If the 5.5 currently has the highest liquidity, and if the MARKET MOMENTUM (which we discussed earlier) is moving to 5.5's, it means that the OAS (option adjusted spread) / yield / price, is going to be the most favorable for seller's (in the sense that they can make more and/or have more buyers to choose from and to buyer's (because they are forced to focus their buying on what's largely available). Plus, all the extra activity in the 5.5 stack means that when an originator goes to sell or a buyer goes to buy, they're not going to have to sit around like a kid at a lemonade stand in the middle of an Iowa (no offense to Iowa LO's, but your population density ain't that great) road, but rather, will be more analogous to a McDonald's in downtown Manhattan.
Whether you're a buyer or a seller, where would you rather be? As a seller, sure, you have to compete with other sellers, BUT, just like the lemonade slinger in Iowa, you might have to wait longer or adjust your terms to complete a transaction. Sure you could charge more to the thirsty sociopath driving by in the stolen car, but how likely is it that said sociopath will drive past your lemonade stand on that hour of that day? (well, pretty likely Iowa, but not as likely in MBS market, again, apologies to Iowa, but hey, statistics are statistics! ). All kidding aside (we actually love you Iowa!) and really the bottom line conclusion, "The action" is in 5.5's now, and traders are betting it will continue to be (in fact, you can see more traders moving money down to even lower coupons – "down in coupon buying"). And both buyers and sellers, despite increasing price pressures for buyers (higher demand = higher price) and decreasing price pressures for sellers (competition, however the competition is offset by the fact that bid demand is outweighing sell demand), simply put, makes everyone want to congregate at the 5.5's. That's the hot party. That's the popular kid. That's where they have to top shelf booze. That's the happenin' place to be… And since our goal is to inform our audience on pricing trends that will affect broad understanding of the market in conjunction with lock/float considerations, AND since pricing trends will be dictated by the trading action of MBS AND (that's the last one) since that "action" is at that party, that's where we're headed tonight.
See ya there!
By the way, I hear it's BYOLR
(bring your own lock request? No? Not even a giggle? I must be losing my comedic edge…)