MBS CLOSE: "Up In Coupon, Up In Coupon"

Around the imaginary Graham/Quinones household this week, it was hard to miss the persistent cadence of Adam dashing around the house, clapping his hands, shouting "Up In Coupon!  Up In Coupon!"  We hear moderately esoteric phrases such as this and may not fully appreciate the gravity.  But just as the Rainman's seemingly lucky guess with matches, there turns out to be more than just random chance behind Adam's writing over the past few weeks.   Up-In-Coupon (UIC) is the common thread with which I will presently weave a brief re-cap of the week that was and the week ahead.

In preparing to think of UIC, think of a soccer field full of 8 year olds.  You've seen it before...  The ball goes to one side of the field and almost every player on the field follows it regardless of position, or frantic shouts from the sidelines.  Sure, some "slower" players don't know what's going on and hang out far behind the ball, while others who are more astute might run ahead of the ball hoping for a pass and potential shot on goal, but the dominant theme is a lemmingistic mass congregation to "whereve da party at."  OK...  Now...  The soccer players are MBS market participants, one end of the field is the lower part of the stack, the other end the higher, and the ball being relatively unimportant to the analogy.  This is basically UIC or "down in coupon" (we don't abbreviate that one) movement.  It's a migration of "closer to par" rates in one direction or another, UIC obviously being up, created by higher and higher demand or perceived value in the higher end of the "stack" (stack meaning simple the range of available MBS coupon rates).  Yeah, well, we had one of those UIC thingies this week, so what?

All about the market climate...

Though there are several factors, such as the inability of originators to get caught up enough to originate much by the way of discounted coupons (even though demand would probably be good for discounts, lenders can't afford the beating they'd take with eleventy gajillion new locks that would result from originating in the low 4% range), the most important factor this week was prepayments.  Imagine if you will, a world where borrowers can pay off their mortgage by refinancing, selling, or going through foreclosure, etc...  We've been discussing this at length and you might remember such terms as "call risk," "call option," or "embedded call risk."  So when we say "embedded call," we're not referring to the risk that someone will call you while you're still in bed, but rather, the intrinsic component of a mortgage loan, the borrower's ability to payoff the principal.  The whole question of "how fast will those borrowers pay these things off?" is utterly central to MBS.  (another cursory glimpse of prepayment speeds as they relate to yield spread is here).

So exercising its immense clairvoyance, the markets had been anticipating the higher end of the stack--let's say 5.5 and higher--to begin to see drastically increasing prepayments as, surely, anyone with a rate so awfully high would be lining up to refinance these days.  Unfortunately for those assumptions, the immense powers of "no duh" would have been a better way to go.  At least in that case, conclusions could have been drawn more accurately about things like credit impairment, underwriting factors at the wholesale level, and primary/secondary spreads?  What am I talkin' bout Willis?  Please, sit down.  If it's not already, all will be clear shortly.

See, everyone thought that higher rate loans would pay off by a certain proportion.  In this "example," lets say the street was expecting 90 billion of prepayments.  But only 70 billion actually prepaid.  Even though this 70 billion may be WAY higher than the previous month (in that sense, the assumptions are 100% correct), remember that the market is always pricing in these expectations.  So because of the drastic drop in rates in late December and early January, analysts and economists were faced with the daunting task of considering the current rate environment against the backdrop of analytical lessons past, to estimate what would happen with prepayment speeds.  In some markets, that's fairly easy, but it's quite difficult in this one, not because of the difficulty itself, but rather because there are ostensibly some "easy answers" that might entice the market to jump to premature conclusions based on broad concepts without first considering some of the minutiae to which "ground zero" loan originators are privvy. 

For instance, it's pretty logical to say: "rates are down, so more people with high rates will refinance."  The consensus was pretty accurate had it not been for a few unique factors currently present in this MBS wonderland, the previous mentioned credit impairment, underwriting factors at the wholesale level, and primary/secondary spreads.  Each of these three concepts, which will be satisfactorily addressed with brief definitions, all should have served to moderate the massive amounts by which the street thought prepayments would have increased.  In other words, "yeah, prepayments are going up for sure, but maybe not quite as fast as you think because of the following 3 things..."  (not only 3 things total, but just 3 of the most salient)

• credit impairment
  • What kind of borrowers usually have higher rate loans?  Right!  And the higher the rate, the tougher the loan usually was in the first place.  And in general, the "tougher" a loan was to do a year or two or three ago, the "deader" that file will be when (or usually "before") it even gets to underwriting.  In other words, on a purely financial level, it makes great sense that the higher the rate, the higher the desire to prepay.  But if those borrowers can't qualify to refi, their ability to prepay goes down drastically.  chalk one up for UIC.
• Underwriting factors
  • This is obviously dovetailed with the previous concept of credit impairment, but it deserves it's own category as there's more to it.  In addition to a higher rate borrower not being able to qualify for a loan based on their own qualifications, there's also the fact that guidelines have tightened immeasurably since they were first originated.  Even if they would qualify "back then," they might not qualify now.  But wait, there's more.  What about turn times?  Sure, the whole world may WANT to refi right now, but if turn times are as long as they are, the expectations are likely skewed to reflect something closer to a normal operating environment in terms of turn time. 
    
• Primary/Secondary Spreads
  • But maybe some borrowers are delaying the process just as much as lenders!  Maybe the street is seeing a current coupon under 4.5 on the MBS market and assuming that mortgage rates would be a bit lower, ok, a lot lower, than they actually are.  With all the factors driving primary spreads higher, not only are borrowers sitting on the sidelines waiting for a lower rates in some cases, but the consensus perhaps didn't realize that the total level of enticement to refi would not be as high because a 4.3 MBS current coupon no longer meant a borrower could get 4.5 with a discount point, but rather something in the low to mid 5's.  Holy Moly!  No wonder less of these things paid off than everyone thought.  Well, most everyone, I'm sure I've heard a few opinions professing UIC moves, not sure where though.

So why does "all of the above" = UIC?  Higher coupons carry higher prices.  Higher prices mean that whoever buys the MBS is paying MORE than the principal amount of the pools in order to collect a higher rate of interest over time.  But that interest stops coming in if the loan pays off, and the buyer is left with simply the principal balance.  Not good if you just paid 103 billion for 100 billion in mortgages.  This is why lenders have EPO penalties, etc..., in order to allow enough interest to come in to cover a good portion of the spread between the principle and the price of the loans.  Premium vs. Discounts...  Capiche?

So higher coupons mortal enemy is the prepayment.  A prepayment kills their return.  And let's say a certain 90 billion dollar amount of prepayments were expected, the MBS market would probably come down in coupon by performing better at the lower end of the stack where prepays are less of a concern.  The dried up demand in the higher end of the stack would bring prices down to a point where investors were willing to risk buying something that was likely to prepay if the premium was 102 as opposed to say 104.  That's "down in coupon."  Now let's say a much anticipated prepayment report comes out showing that prepayments were 70 billion instead of 90 billion, and all that "pressure" that was built-in to the expectations can now be released.  All of a sudden the higher coupons aren't as scary as they were supposed to be and investors, seeing that they've become relatively undervalued by the expectations, can move back into them, thus driving average rates up.  Or more accurately, thus shifting a majority of whatever MBS buying is going on disproportionately in favor of higher coupons.  If all of MBS wins, high coupons win bigger.  And if they sell, as they did today, the high end of the stack stays relatively unbruised, while 4.0's and 4.5's are soundly beaten.

UIC.  Up in Coupon.  We Cool?

Yes, it is temporary, expected, natural part of the cycle, and rates can still improve, but we will be covering all of that anon.  For now, this is the flavor of the week.  This post has gotten long to the point that I'm going to post it as is, and come back to you later with pertinent headlines from the week and a look ahead.  (after all, I have to ease back into it after being kidnapped by pirates for the past two weeks).