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Why “fast” mortgage servicers crush the TBA bond market

Deutsche Bank analysts: Prepayments costing hundreds of millions per year

One type of help for homeowners is not giving a hand to mortgage bond investors.

A new segment of lenders and servicers that specialize in quicker prepayments is costing the To-Be-Announced mortgage bond market “several hundred million of dollars a year,” analysts from Deutsche Bank Markets Research said in a new report. The government-sponsored enterprises Fannie Mae and Freddie Mac trade on the TBA market, as well as Ginnie Mae.

According to Deutsche Bank analysts Steven Abrahams, Christopher Helwig, Jeana Curro, Ian Carow and Jeff Ryu, the share of lenders and servicers that are delivering faster prepayments is increasing, and that creates a whole new set of problems for TBA investors.

“The rise of a new set of lenders and servicers in agency MBS has brought a new issue to the TBA pass-through market: prepayment speeds well above the market average and prices that have started to reflect it,” the analysts said in a new report.

“Some investors have tried to avoid one servicer or another in their TBA flows, but the growing share of faster players makes that strategy untenable for most portfolios,” the analysts continued. “TBA prices consequently have to reflect the new risk. That looks like it is already costing the MBS market several hundred million dollars a year.”

According to the Deutsche Bank report, several servicers, including Quicken Loans, Flagstar Bank, and Provident Lending prepaid faster than the rest of market for most of 2014. When the bonds prepay, it's because the homeowner refinances out of the current mortgage, so investors stop getting their cut on interest payments.

“Under the higher rate and more benign prepay environment of 2014, that speed differential drew little attention except in parts of the market where new servicers and refinancing incentives mixed,” the analysts said.

But the rally that started 2015 and the new servicer’s rising market share brought the “latent prepayment risk” to a broader audience, the analysts added.

“Some investors have simply tried to avoid these servicers by either buying single servicer specified pools or stipulating for TBA delivery without them,” the analysts said. “Although effective, the scalability of that strategy is limited. As fast servicers’ share grows, market makers run increasing risk of failing to deliver on stipulated trades. Fast servicers also can show up in ‘Giant’ and ‘Mega’ pools. These problems become more acute if fast servicers’ share of the float continues to increase.”

Going forward, the analysts say that the price of TBA has to reflect the probability of receiving unusually fast pools, including pools with speeds driven by servicers.

“This is an element of risk beyond the usual impact of large loan balances or high FICO scores or geography or any other attributes of the loan that contribute to negative convexity,” the analysts said. “Loan attributes mix with the impact of pool age and refinancing incentive and other factors to create a monthly distribution of prepayment speeds above and below the average. Analysis of speeds in pools handled by these faster servicers suggests that it is more than just the attributes of the loans; even after accounting for most loan attributes with Deutsche Bank’s prepayment model, speeds in these servicers’ pool still tend to come in faster than expected.”

The analysts add that fast servicers add to the tail of speeds of the average, which raises the risk in the TBA market, and suggest that the market needs to begin pricing for this condition.

Additionally, the analysts suggest some potential solutions to the fast servicer issue.

“Some analysts have recommended that Fannie Mae and Freddie Mac create large multi-issuer pools similar to those produced in Ginnie Mae II MBS, which would, in theory, expand the TBA deliverable to include the entire free float net of CMOs and the Fed,” the analysts said. “While this approach would likely dilute the impact of faster speeds, it would still allow faster services to extract a subsidy, for which the rest of the market would have to pay some price.”

Alternatively, the analysts suggest making consistently fast servicer pools non- deliverable for TBA until return to expected payment speeds. This approach would pass the costs of aggressive servicing back to the servicers and their borrowers through pool pricing, the analysts said.

“The real complication comes when considering the benefits inside and outside of TBA. A more efficient set of servicers adds to the negative convexity of MBS, lowers their fair price and raises the implied mortgage rate for borrowers,” the analysts said.

“But more efficient refinancing also helps the consumer balance sheet through lower average mortgage rates,” the analysts continued. “Inside the MBS market, faster servicers and their rising share might look like a problem. Outside the market, it just might look like the American Dream.”

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