Specified Pools

UNITED STATESM April 18, 2011 (First published on November 2, 2005) A M A R K E T Q U A N T I T A T I V E A N A L Y S I S Mortgages UNITED STATES Robert Young (212) 816-8332 [email protected] New York Specified Pools: Superior Prepayment Profiles Offer Added Value This Commentary has been prepared by Markets Quantitative Analysis ("MQA"), which is part of Citigroup Global Markets' sales and trading operations. DDDD M April 18, 2011 (First published on November 2, 2005) A Specified Pools: Superior Prepayment Profiles Offer Added Value ¾ TBA sellers have an incentive to deliver pools with poor prepayment characteristics: faster than average for premium pools and slower than average for discount pools. ¾ Owing to call protection or extension protection, “specified” pools are considered more valuable than TBA pools. Specified pools are priced based on a premium, or pay-up, to the TBA price. ¾ Originators that sell mortgages to the agencies, pool them in a manner that maximizes the value of the resulting MBSs they receive in return for their loans. ¾ Two common methods for determining the value of a specified pool relative to TBA are carry-based valuation and OAS-based valuation. Each has advantages and disadvantages. This Commentary has been prepared by Markets Quantitative Analysis ("MQA"), which is part of Citigroup Global Markets' sales and trading operations. ............ 14 Loan Age: Good News for the Young and the Old ..................................................................................................................................................... Conclusion 29 Acknowledgements We thank Brett Rose and Lakhbir Hayre for their helpful suggestions.............................................. 4 Citigroup Global Markets ...................................................................................................................... 27 Scenario Analysis — What If Rates Move?... The authors would also like to thank Peg Pisani for editing the report and Adela Carrazana for providing production editing............. 8 GEO: Location............................................................ Specified Pool Creation: A “Waterfall” of Pooling 7 Loan Balance: The Once and Future King........ Carsten Schwarting for guidance on the structure of the specified pool market................................................................................................................ 27 IV........... 13 Poor Credit: Usually Slower........................................... Location....................... 11 Investor Property Loans: A Nice Place to Visit ........ 18 Purchase Loans: Nothing to Write Home About............ Location ......................................................................November 2.......................................................... 19 III......... Unless It’s Faster............................ TBA: Cheapest-to-Deliver 5 II......... 16 WAC: Show Me the Money................................................................. 21 OAS-Based Valuation ............................................................................................ Specified Pool Value: Enhanced Returns Through Superior Convexity 21 Carry-Based Valuation ..................... 22 Comparison of Carry and OAS Valuations.................. 2005 Specified Pools: Superior Prepayment Profiles Offer Added Value Contents I. and Buchi Ramagopal and Mikhail Teytel for their insights................................................. However. By allowing forward contracts with standardized delivery. what do they do when they want to sell pools with good prepayment profiles? Sellers sell pools with good prepayment profiles on a “specified” basis. product. limited. the individual pool is not known at the time of the trade. Examples of this adverse selection process in the TBA MBS market are known as “worst-to-deliver” or “cheapest-to-deliver. maturity term. TBA sellers have an incentive to deliver pools with poor prepayment characteristics: faster than average for premium pools and slower than average for discount pools. they sell the individual pool rather than a generic TBA. Citigroup Global Markets 5 . and settlement date. The table lists some of the well-known specified attributes and shows the outstanding balance for ranges correlated with slower. 2005 Specified Pools: Superior Prepayment Profiles Offer Added Value I. As prepayment models evolved.” If sellers deliver pools that they believe have poor prepayment profiles into TBA trades. in general. so other pool attributes cannot be identified. TBA: Cheapest-to-Deliver The creation of the to-be-announced (TBA) MBS added significant depth to the mortgage market. market participants realized that certain attributes were correlated with slower prepayment speeds while others indicated that a pool had a higher propensity to prepay. It also gave the MBS seller the ability to choose which pools to deliver into the forward trade. keeping the pools that they deemed to have the most attractive characteristics. and coupon.November 2. the amount of outstanding balance with characteristics suggesting a pool will have prepayment speeds that differ significantly from the overall averages is. in addition to the par amount. price. A specified pool has certain attributes that predictive models assess as having a likelihood for prepayments that is different than the overall aggregate average — slower for premium coupon pools or faster for discount coupon pools. That is. the TBA mortgage added the liquidity necessary for the market to flourish. TBA trading requires the specification of the agency. Sellers became more discerning in their choice of what to deliver into a TBA trade. Figure 1 shows the outstanding balance for various categories of specified attributes as of August 2005.or faster-than-average prepayment speeds. While originators have grown more sophisticated in pooling their mortgage loans. 235 1.467 4 2 3 90 Occupancy Status Owner Occupied Second Home Investor Property 1.901 1.245 40.650 2 15 82 WAC Low WAC (5.675.026.997 90 4 4 Loan Purpose Purchase Refinance 614.377.658.519.479 145.514.475.695 89.725 1.610 96.174 2 10 88 LTV High LTV Very High LTV Normal LTV 80 > LTV >= 90 LTV > 90 LTV <= 80 124. DLJ All Other Originators 17. 6 Citigroup Global Markets . 2005 Specified Pools: Superior Prepayment Profiles Offer Added Value Figure 1.536 139.697 50.188 37 61 FICO Low FICO Very Low FICO Normal FICO 600 <= FICO < 650 FICO < 600 FICO >= 650 38.413 895.492 348.166 38 Indymac.649 59.898 6 6 8 21 5 53 1.644 100 All Other Production Other Alt-A Prime Production GEO New York Texas Florida California Illinois Other States Grand Total All Pools 62 Source: CPR & CDR Technologies. Total 70. Conventional 30-Year Outstanding Balance by Specified Attribute.261 31.595 1.November 2.040.857 1. Greenpoint.00%) Servicing Spread <= 50bp 635.614 161. Aug 05 Attribute Specified Value Definition Loan Balance Low Loan Balance (LLB) Mod Loan Balance (MLB) High Loan Balance (HLB) TBA Max Loan Size <= 85K 85K < Max Loan Size <= 110K 110K < Max Loan Size <= 150K Max Loan Size > 150K Outstanding ($MM) Pct.049 1 99 105.482 7 2 91 Age Low WALA (Premium Cpns) Seasoned (Discount Cpns) All Other Production WALA <= 3 WALA >= 24 41.720 256.274 1.622 67.512.079 1.50%-6. with value flowing downstream. “specified” pools are considered more valuable than TBA pools. and they eventually reach a plateau within about two years. The weighted average loan age (WALA) identifies where a pool is in its life cycle. In other words. leaving less rate-sensitive borrowers to comprise a growing percentage of the remaining pool balance. 1 this process can be characterized as a waterfall.” The seasoning ramp is well known to MBS investors. Originators that sell mortgages to the agencies. 2005 Specified Pools: Superior Prepayment Profiles Offer Added Value II. to the TBA price. whereas a borrower with a note rate at or below current rates has no such incentive. 2001 and 2002 production 4 are prepaying at about the same rate as 2003 production. Intuitively.November 2. 3 Also. at least in 2 the prevailing interest rate environment. Specified Pool Creation: A “Waterfall” of Pooling Owing to call protection or extension protection. A quick glance at any prepayment report shows that 2005 (i.3 Second. but for now we will simply state the hierarchy of relative value. Because the coupon of the security is one of the attributes known at trade time. current year) originations are paying. 4 Older vintages tend to exhibit slightly slower prepayment speeds as burnout begins to take effect. or pay-up. As pools age. Citigroup Global Markets 7 . The composition of borrowers in a pool changes as more rate-sensitive borrowers self-select out of pools (prepay). 2 Simply put.e.00% pools.” With regard to security attributes. First. The second most important security attribute is the age of the loans in the pool. it seems obvious that a borrower with a note rate significantly above the currently available mortgage rate has an economic incentive to refinance. their prepayment speeds tend to increase. because people usually do not move again quickly. having been institutionalized in the form of the PSA ramp. higher coupons prepay faster than lower coupons. slower than 2004 or 2003 originations for the same coupon. in turn. pool them in a manner that maximizes the value of the resulting MBSs they receive in return for their loans. the incidence of refinancing for noneconomic reasons soon after closing is similarly low. Originators select the coupon and distribution channel that provides the highest value. on average. prepay faster than 5. the number of rate refinancers is low. because it is unlikely that rates would have decreased enough to justify another outlay of closing costs. the buyer of a TBA has an idea of the expected range for prepayment speeds.. Most broker/dealers stratify their prepayment reports by coupon and year of origination (vintage) for this reason. a process known as “best execution.00% pools. The gradual increasing of prepayment speeds in the early life of a pool is referred to as “seasoning. The most basic determinant of prepayment speeds is the borrower’s incentive to refinance. specified pools are priced based on a premium. 6. Figure 2 shows the standard PSA 1 We will cover the actual valuation techniques later. The pooling decision hinges on the relative prices of individual security coupons at the time of sale. With the TBA serving as a commoditized baseline product. At the same time.50% pools which. Borrowers generally do not pay off their mortgages within a few months of obtaining them for several reasons. on average. prepay faster than 5. turnover tends to be low. such as the record refinance wave of 2003. Indeed.November 2. The next few sections cover some of these attributes. Figure 2. particularly for in-the-money coupons. In the current market environment. Standard PSA Ramp 8% 7% PSA Ramp 6% CPR 5% 4% 3% 2% 1% 0% 0 6 12 18 24 30 36 42 48 54 60 Month Source: Citigroup. Loan balance is considered one of the most important factors in predicting prepayment speeds. loan balance is the most reliable predictor of speeds. that constitutes the large majority of the agency mortgage universe. 8 Citigroup Global Markets . a given rate reduction results in a smaller decrease in the borrower’s monthly payment. its main use is related to CMOs (PAC bands). measuring the rate incentive using only the difference between the borrower’s note rate and the 5 Although the PSA ramp has limited usage in the current market environment. Each attribute is segregated in a particular order to maximize the total value of the 6 portfolio of loans to be sold. The differential has held consistently during periods of high aggregate prepayments. Therefore. 2005 Specified Pools: Superior Prepayment Profiles Offer Added Value ramp. They take the most valuable loans and pool them together to capture the market’s pay-up for the specific attribute(s). The basic premise is that for a lower loan balance. Originators also recognize the extra value that can be extracted by grouping certain attributes and pooling their loans accordingly. many other attributes can be used to further refine estimates of prepayment speeds. 6 Once all of the attributes that can be isolated to give additional value are segregated from an originator’s portfolio of loans. the remainder is packaged into pools that are destined for the TBA market. after rate incentive and age. in which prepayment speeds increase linearly for 30 months before leveling 5 off at 6% CPR for the remainder of the mortgage term. it was the standard expression for prepayment speeds in the early development of the MBS market. As shown above. Low loan balance pools have consistently prepaid slower than their higher balance counterparts for in-the-money coupons. Loan Balance: The Once and Future King The first groups of loans to be segregated into their own pools are loans with low loan balances. The market recognizes these attributes and is willing to pay a premium to TBA for them based on the magnitude and consistency of their differentials from the aggregate averages. as well as periods when aggregate prepayment speeds have been considerably slower. After coupon and age. 000 but falls by $197 on a loan balance of $300. LLB pools provided tremendous protection against prepayments. P&I Payments Based on Note Rate and Loan Balance Rate (%) 5.5 8.000 537 568 600 632 665 699 734 1.201 Source: Citigroup. rates were the lowest they had been in four decades and the yield curve was close to 300bp steep (ten-year minus two-year rates).0 6.000 (MLB) are pooled next. referring to the first two categories as LLB1 and LLB2 and the third as MLB.610 1. The “S” curves from the refinance wave can only be shown for premium coupon pools where the WAC is at least 50bp in the money because. The generally established categories are for pools with a maximum loan size less than $85.703 1. with speeds as much as 30% CPR or more slower than the aggregate averages for individual cohorts.000 (high loan balance. Figure 3 shows a borrower’s principal and interest (P&I) payment for a given rate for various loan balances.000 $200. or “HLB”).000 for LLB.136 1.468 1.264 1.199 1.5 7.098 2. In short.0 $100. Of the remaining loans.November 2. the monthly P&I payment decreases by $65 on a loan balance of $100. those with balances less than $110.0 7. but the loan size thresholds are consistent for conventional pools.0 5. However. 7 that is the highest individual loan size in the pool.398 1.0% to 6.331 1. 8 and maximum loan size less than $150. For example. for a rate reduction from 7. LLB pools command the highest pay-ups in the world of specified pools. because originators are meticulous about how they pool loans.000 (LLB) separately. $110.000 $300. and $150.000 for HLB.000 (HLB). Figure 3.5 6. as was noted at the time.896 1.074 1.996 2. or “MLB”). there were no discounts. maximum loan size less than $110. followed by those with a balance less than $150. Specified loan balance pools are marketed according to their maximum loan balance. The loan balance thresholds for GNMA pools are $75. most pools have a very narrow range of loan sizes.799 1.000 (moderate loan balance.000 for MLB. Figure 4 shows prepayment speeds for fully seasoned 2001 production during the height of the refinance wave in 2003. 7 Using the average loan size would convey more information about a pool.000 (low loan balance. The difference in payments represents the reduction available from refinancing to a lower rate mortgage. Citigroup Global Markets 9 . or “LLB”).000. 8 Some market participants use different nomenclature.0%. 2005 Specified Pools: Superior Prepayment Profiles Offer Added Value currently available mortgage rate only tells part of the story. Originators first pool loans with balances less than $85. hence. Citigroup Global Markets . “S” Curves for 2003 Production During the Current Year. they calculate their potential monthly mortgage payment based on the home they are considering purchasing. and the yield curve was relatively flat. Jan 05–Jul 05 CPR (%) 50 45 LLB 40 MLB 35 Total 30 25 20 15 10 5 0 -150 -100 -50 0 50 Rate Incentive (bp) 100 150 200 Sources: CPR and CDR Technologies. While loan balance is significant for refinances it makes little difference for 9 turnover. If the payment is too great. show little difference between size categories. However. “S” Curves for 2001 Production During the Apr 03–Sep 03 Refinance Wave 80 70 60 CPR (%) 50 40 30 20 10 LLB MLB Total 0 0 50 100 150 200 250 Rate Incentive (bp) Sources: CPR and CDR Technologies. when rates were still low by historical standards but higher than the generational lows of 2003. the decision to move is essentially independent of the 10 loan balance on the current mortgage.November 2. 10 10 The current LTV does determine the amount of equity available for a down payment on a new house. they are forced to purchase a less expensive home or postpone moving. Figure 5 shows the “S” curves for fully seasoned 2003 production in the first half of 2005. Figure 5. 9 Discount coupon speeds are mostly due to turnover and. 2005 Specified Pools: Superior Prepayment Profiles Offer Added Value Figure 4. When borrowers contemplate moving. November 2. but the small outstanding balance makes them hard to find and sparsely traded. In some cases. Pools that have a high concentration of loans from a particular state might command a pay-up (referred to as “geo” pools) depending on whether the state prepays faster or slower than average and the pool is in or out of the money. This tax historically had slowed prepayments in Florida to below the national average. CPR differentials for premium coupons on the cusp range from 5% to 10% CPR and for higher premiums can be as much as 15%–20% CPR. with prepayment speeds up to 70% slower than the aggregate averages. For example. however. Figure 6 shows “S” curves for fully seasoned 2001 production for some historically slow prepaying states during the 2003 refinance wave. 11 Puerto Rico pools are actually the most valuable. However. 2005 Specified Pools: Superior Prepayment Profiles Offer Added Value Out-of-the-money speeds are virtually on top of each other. is still quite consistent for in-the-money pools. Texas is also consistently slower than the aggregate average because of restrictions on cash11 out refinances and higher-than-average closing costs. There is no difference for pools that are 50bp or more out-of-the-money. originators segregate loans from states that have historically slow prepayments. even though overall aggregate speeds are at their long-term historical averages. Prepayments tend to be slower in New York for in-the-money coupons. Florida has experienced significant home price appreciation over the past several years that appears to have offset the effect of the mortgage tax. GEO: Location. Location. Location Once all loans below the loan balance thresholds are removed. while in-the-money speeds still show distinct differences based on loan size. The CPR differential between LLB pools and higher balance pools. Figure 6. Citigroup Global Markets 11 . Slow State “S” Curves for FNMA 2001 Originations in the 2003 Refinance Wave 80 70 60 CPR (%) 50 40 30 20 New York Florida National Average 10 Texas Puerto Rico 0 0 50 100 150 Rate Incentive (bp) 200 250 Sources: CPR and CDR Technologies. New York is the best-known geo story because of a mortgage recording tax that raises the effective mortgage rate available to the borrower by 1% (2% in New York City). Florida has a mortgage tax of 55bp. higher-than-average loan sizes or strong home price appreciation may mitigate the effects of geo trends. Figure 7 shows the “S” curves for the same states for 2003 production in 2005. as mentioned. 2005 Specified Pools: Superior Prepayment Profiles Offer Added Value The states mentioned above were prepaying consistently slower than the national average for in-the-money pools. Slow State “S” Curves for FNMA 2003 Originations in 2005 70 60 50 New York Texas Florida CPR (%) Puerto Rico 40 National Average 30 20 10 0 -150 -100 -50 0 50 100 Rate Incentive (bp) 150 200 250 Sources: CPR and CDR Technologies. Figure 8 shows the “S” curves for some historically faster-prepaying states in 2005. 12 Citigroup Global Markets .November 2. Figure 8. a discount coupon pool with a high concentration of loans from a state with fast enough housing turnover speeds could warrant a modest pay-up. Collateral from faster-prepaying states — such as Illinois and Michigan. However. which have low closing costs for refinancing — typically ends up as TBA collateral. Note that Florida is now paying slightly above the national average. there were no discounts at the time. Figure 7. Fast State “S” Curves for FNMA 2003 Originations in 2005 80 70 60 CPR (%) 50 California Massachusetts Illinois Michigan National Average 40 30 20 10 0 -150 -100 -50 0 50 100 Rate Incentive (bp) 150 200 250 Sources: CPR and CDR Technologies. The rate incentive only goes down to zero because. the attributes were used as a basis for specified pay-ups. while paying virtually on top of owner-occupied properties for out-of-the-money pools. and (3) investors generally have less commitment to a mortgage transaction than an owner-occupant. 2005 Specified Pools: Superior Prepayment Profiles Offer Added Value Investor Property Loans: A Nice Place to Visit In the summer of 2003 the agencies began to release additional disclosure items for pools including the original FICO. only pools with a very high percentage of investor properties (close to 100%) command a pay-up. which are slower to process and approve. and owner-occupied properties for pools with an average loan size greater than $150. In the current environment. Figure 9 shows the “S” curves for second homes.000) 60 50 CPR (%) 40 30 20 10 2nd Home Investor Owner 0 -100 -50 0 50 100 Rate Incentive (bp) 150 200 250 Sources: CPR and CDR Technologies. It shows that investor properties consistently prepay slower for in-the-money pools. the pay-up is usually in the range between those for MLB and HLB pools. 13 . and initially. (2) they are generally full-documentation loans.5% to 2. original LTV. The basis for the pay-up is the market perception that non-owner-occupied properties are harder to refinance than owner-occupied properties. 12 Citigroup Global Markets The agencies charge fees ranging from 1. Investor loans often face a greater hurdle to refinancing: (1) They are generally more difficult to originate as investors tend to have more complex financial situations. As a result. however. borrowers taking out a mortgage loan for an 12 investment property are generally charged higher rates. Despite the above-average loan sizes. “S” Curve by Occupancy Status (Average Loan Size > $150. Although underwriting guidelines for non-owner-occupied collateral are stricter. For a pool with 100% investor properties.000. investor properties. specified pool trading for investor properties typically involves above-average loan size collateral. because low-loan-size investor loans have already been placed into more valuable LLB pools.5%. specified pools with a high percentage of investor loans do appear to offer prepayment protection. depending on the LTV.November 2. Figure 9. occupancy status. loan purpose. The implementation of the new disclosure generated a great deal of anticipation. and property type. November 2. investor property pools have average borrower note rates that are about 35bp–45bp higher. 14 Citigroup Global Markets . It was thought that borrowers with mortgage note rates significantly above the generally available rate at the time of origination must have had impaired credit. When the agencies began to release FICO and LTV data in June 2003. which were slower than conventional speeds during the refinance wave of 2003 but recently have been faster than conventional speeds. as well as the overall averages. Poor Credit: Usually Slower. Before 2003. prepayment speeds were as expected: Low-FICO and high LTV speeds were considerably slower than their higher-FICO and lower-LTV counterparts. the market used the spread-at-origination (SATO) as a proxy for creditworthiness. Unless It’s Faster Low FICO scores and high LTVs were thought to indicate slower prepayment speeds because borrowers with impaired credit find it harder to refinance. since that time. investor properties. which has been significant over the past several years. Figure 10 shows the seasoning ramps for second homes. and owner-occupied properties for pools with an average loan size greater than $150. however. In general. Borrowers with newly found equity in their homes may be 13 The phenomenon is consistent with GNMA prepayment speeds. otherwise they would have gotten the prevailing rate for prime borrowers. Part of the reason for this trend lies in home price appreciation. Original LTVs from just a few years ago have been rendered obsolete. because for pools of the same age (the loans were originated at the same time). owner-occupied properties merit a better rate than non-owner-occupied properties. Lower-FICO and higher LTV pools have prepaid faster than their complements and the overall 13 aggregate averages.000. the credit story has turned upside down. investor properties prepay more slowly. for identical rate incentives. As shown. The investor property ramp is higher than the owner-occupied ramp.000) 30 25 CPR (%) 20 15 10 5 2nd Home Investor Owner 0 0 6 12 18 24 30 Months Sources: CPR and CDR Technologies. Figure 10. Seasoning Ramp by Occupancy Status (Average Loan Size > $150. However. 2005 Specified Pools: Superior Prepayment Profiles Offer Added Value The seasoning ramps for the different occupancy status categories have the same general slopes and are equivalent in length. originators are willing to reach down the credit spectrum to refinance less creditworthy borrowers. The EA “S” curves are considerably below the overall aggregate average. To determine credit impairment. With many prime borrowers already in lower-rate mortgages. and a servicing spread of 100bp–140bp. and a servicing spread of 60bp–100bp. In this figure. those attributes do not command pay-ups on their own. but experience indicates that the average ranges of attributes for EA-1 are a FICO score of 600–650. Aggressive solicitation by overstaffed originators has also contributed. we use a combination of attributes derived from FNMA’s Expanded Approval (EA) program. and a servicing spread of 50bp–60bp. LTVs of 80%–95%. Credit-Related “S” Curves in the 2003 Refinance Wave 80 EA-1 70 EA-2 60 EA-3 50 Total 40 30 20 10 0 -100 -50 0 50 100 Rate Incentive (bp) 150 200 250 Sources: CPR and CDR Technologies. demonstrating the validity of the credit story at the time.November 2. Figure 11 shows 2001 production during the 2003 refinance wave. In the current environment. an original LTV of 75%–90%. 14 These pools are not identifiable as such. Market participants look for a combination of attributes that indicate true credit impairment and may pay-up slightly for pools that they believe include borrowers who have yet to cure their credit problems. CPR (%) Figure 11. EA-2 ranges are FICO scores of 590–620. although they are considerably closer than in 2003. Other borrowers may be able to extract the equity to clear up lingering credit blemishes. Figure 12 shows 2003 production in 2005. LTVs of 80%–95%. 2005 Specified Pools: Superior Prepayment Profiles Offer Added Value able to refinance into lower-rate mortgages than they qualified for before. the EA “S” curves are above the overall aggregate averages. Citigroup Global Markets 15 . EA-3 ranges are FICOs of 560–600. The EA program reclassifies loans that were previously rated as “caution” in FNMA’s Desktop Underwriter (DU) automated underwriting system into additional 14 levels of approval. and the like. Refinances do not require borrowers to move. 2005 Specified Pools: Superior Prepayment Profiles Offer Added Value CPR (%) Figure 12.November 2. Credit Related “S” Curves in 2005 70 EA-1 60 EA-2 50 EA-3 40 Total 30 20 10 0 -100 -50 0 50 100 150 200 250 Rate Incentive (bp) Sources: CPR and CDR Technologies. Loan age can command a pay-up in its own right. that means low-WALA pools. it means older. Of course. Understanding speeds in terms of a ramp is simple enough for turnover. The market is paying up only for in-themoney pools that are three months old or less. such as a new appraisal. For example. because the expectation is that it will prepay faster than newer 15 Lenders also try to discourage refinances that occur soon after the previous refinance. The process of taking out a mortgage involves costs. As their tenures in their homes increase over time. Pay-ups for loan age are generally small compared with loan balance pay-ups. borrowers may be reluctant to refinance if they 15 have refinanced very recently. closing costs typically can run up to several thousand dollars. but can occur either in the beginning of the ramp or further along the ramp. or fully seasoned pools. depending on whether the pool is in or out of the money. 16 Citigroup Global Markets . title search. but there are reasons for a ramp to exist for in-the-money loans as well. in which no origination points are charged for the mortgage. property recording fees. For example. a low-WALA pool remains low-WALA for only a few months. Borrowers generally do not move within a few months of buying a new home and taking out a new mortgage. In other words. even if rates have declined again. LLB pools command a higher payup if they are also low WALA. loan age is a transient attribute. Even if a borrower refinances into a so-called “no point” mortgage. but it is also used in conjunction with other attributes. as opposed to being a year old. As a result. borrowers begin to move and payoff their mortgages. Loan age has long been recognized as a primary determinant of prepayment speeds. A fully seasoned discount can also command a pay-up. The original PSA ramp institutionalized the fact that speeds on new pools tend to be slower than the overall average and “ramp up” over time. for out-of-the money (discount) coupons. For in-the-money coupons. Loan Age: Good News for the Young and the Old The next attribute to be segregated is loan age. one major lender states in its seller guide that an originator that sells it a loan that prepays within 90 days is held responsible for any losses resulting from lost servicing rights and a premium purchase price. Figure 14 shows seasoning ramps for five different levels of rate incentive ranging from 100bp out of the money to 150bp in the money. 2005 Specified Pools: Superior Prepayment Profiles Offer Added Value pools with the same coupon. the ramp tends to be longer and have a gentler slope. Very seasoned pools also have shorter legal final 16 maturities. Figure 13. When the level of interest rates is high. In addition. the ramp is steeper and peaks sooner. Although the PSA ramp is fixed in length and magnitude. “cuspy” is defined as having a rate incentive between 0bp and 50bp. which can decrease extension risk. speeds also reached their fully seasoned level in about 12–15 months and actually begin to taper off slightly after that. For positive rate incentives. the ramp becomes shorter and steeper. which is also included in most prepayment models. This illustrates the value of low-WALA pools for in-the-money pools. whereas for the refinance wave of 2003 speeds reached their fully seasoned level at about 12–15 months. Seasoning Ramp for Cuspy Coupons (0bp–50bp Rate Incentive) 60 Apr 00–Sep 00 50 Apr 03–Sep 03 Jan 05–Jul 05 CPR (%) 40 30 20 10 0 0 6 12 18 24 30 Age (Months) Sources: CPR and CDR Technologies. During a period of high rates in 2000. Figure 13 shows the seasoning ramp for cuspy coupon pools for three different periods. 16 Citigroup Global Markets Very seasoned premium collateral can also be of value owing to favorable convexity characteristics (burnout.November 2. for outof-the-money pools the ramp becomes fully seasoned at about 24 months. As rates decline. 17 . for example). it is useful for understanding the concept of the seasoning ramp. Seasoning ramps can have different lengths depending on the rate incentive. sometimes dramatically so. In this case. depending on economic conditions and the interest rate environment. In 2005. the ramp peaked at about 24 months or so. Modern attempts to model the seasoning ramp account for the fact that it can vary over time. WAC: Show Me the Money As mentioned. In our LLB example. 18 18 To qualify for TBA good delivery.75% to 6. known as the servicing spread.00% pool or a 5. 25bp is the minimum servicing spread. Within a given coupon. “low-WAC” pools commanded pay-ups in their own right. on balance. How can pools with the same security coupon have such different WACs? Agency pooling requirements specify that a loan note rate must be at least 25bp higher than the security coupon of the pool into which it is placed. In the current environment. lower WACs are considered an enhancement to other specified attributes. can be anywhere from 25bp to 100bp or more. During the height of the refinance wave in 2003 and for while after. ensuring that each loan has at least 25bp of servicing spread 18 attached. For example. Seasoning Ramp by Rate Incentive -100bp to -50bp 50bp to 100bp 50 -50bp to 0bp 100bp to 150bp 0bp to 50bp 45 40 CPR (%) 35 30 25 20 15 10 5 0 0 6 12 Age (Months) 18 24 30 Sources: CPR and CDR Technologies.November 2. Small changes in the rate incentive have a large impact on prepayment speeds. Clearly. a 5. and thus.50% pool. 17 From a modeling perspective. 2005 Specified Pools: Superior Prepayment Profiles Offer Added Value Figure 14. this corresponds to the steepest part of the “S” curve where convexity effects are greatest. for all practical purposes. However.5% pool can have a WAC that ranges anywhere from 5. For slightly in-the-money coupons on the cusp of being refinanceable. there is no maximum WAC for a loan to be in a pool. however. a loan with a note rate of 6. When an originator sells a loan to one of the agencies. The difference between the WAC and security coupon. the rate incentive is the most important determinant of prepayment speeds with the security coupon giving a general range of expectations for speeds. pools can have a wide range of WACs. a greater incentive to refinance as rates decline. For example. have higher WACs. Citigroup Global Markets . the 17 difference in WAC can have a significant impact. it has a choice as to the security coupon of the pool. a cuspy coupon LLB pool with a servicing spread of 25bp would command a higher pay-up than a LLB pool with the same security coupon but a servicing spread of 75bp.50% or higher.25% can be placed into either a 6. higher-coupon pools will. The weighted-average coupon (WAC) is the weighted average of borrowers’ note rates in a pool and determines the rate incentive. they were still considerably slower than the overall aggregate averages. Figure 16 shows the “S” curves for purchase money and refinance loans. Market participants are aware of this and are not willing to pay up for pools with higher percentages of purchase money loans. the evidence does not support the initial hypothesis. Purchase Loans: Nothing to Write Home About When the agencies first began their additional disclosures in 2003. A higher-premium coupon has a considerable incentive to refinance regardless of the servicing spread. Figure 15. comprised a mix of rate-sensitive borrowers with borrowers who were not as rate sensitive.00% Pools by Servicing Spread. overall aggregate 6.Svcg Spread 75bp–100bp Overall Aggregate Average 80 70 60 CPR (%) 50 40 30 20 10 0 Jan 03 Apr 03 Jul 03 Oct 03 Jan 04 Apr 04 Jul 04 Oct 04 Jan 05 Apr 05 Jul 05 Sources: CPR and CDR Technologies. were thought to signal slower prepayment speeds. would refinance more slowly than refinance loans. during the height of the refinance wave in 2003. 2005 Specified Pools: Superior Prepayment Profiles Offer Added Value The additional pay-up is generally restricted to cuspy and slight premium coupons. FNMA LLB 6. The LLB pools with smaller servicing spreads. corresponding to lower WACs. by contrast. In addition.Svcg Spread 50bp–75bp LLB . Thus far. there appears to be little difference between the prepayment speeds of purchase money and refinance loans. however. turnover could be higher for refinance loans. Jan 03–Jul 05 LLB . For example.00% coupon speeds peaked above 70% CPR compared with the high-servicing-spread LLB speeds of less than 50% CPR. Citigroup Global Markets 19 . as opposed to refinance loans. Purchase money loans. The prevailing wisdom was that purchase money loans. because the refinance loans represented borrowers that had already shown themselves to be sensitive to positive rate incentives and able to take advantage of them. Instead.November 2. because they were already seasoned in terms of the borrower’s tenure in the home. pools with a higher percentage of refinance loans should prepay faster. Figure 15 shows the effect of different WACs for LLB 6. on average. high percentages of purchase money loans. Based on relative percentages.Svcg Spread 25bp–50bp LLB . consistently prepaid slower than 19 LLB pools with higher servicing spreads (higher WACs). 19 Even though the higher-servicing-spread LLB prepaid faster than the lower-servicing-spread LLB.00% pools from the beginning of 2003 through August of 2005. Figure 17.November 2. the ramps for purchase money and refinance loans cross a couple of times before settling into a long-term pattern with purchase money loans prepaying slightly faster than refinance loans after about the first year or so. 20 Citigroup Global Markets . Figure 17 shows the seasoning ramps for purchase money and refinance loans. further supporting the notion that borrower tenure is further along the seasoning ramp for the refinance loans. the purchase money and refinance curves are virtually on top of each other with purchases marginally higher on super-premiums. For in-the-money pools. “S” Curve by Loan Purpose 40 35 CPR (%) 30 25 20 15 10 5 Purchase Refinance 0 -100 -50 0 50 100 150 Rate Incentive (bp) 200 250 300 Sources: CPR and CDR Technologies. For out-of-the-money pools. The ramp for out-of-the-money refinances rises faster than the purchase money ramp. Seasoning Ramp by Loan Purpose 35 Out-of-the-Money Purchase In-the-Money Purchase Out-of-the-Money Refinance In-the-Money Refinance 30 CPR (%) 25 20 15 10 5 0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 27 28 29 30 Age (Months) Sources: CPR and CDR Technologies. for in-the-money pools. 2005 Specified Pools: Superior Prepayment Profiles Offer Added Value Figure 16. lending some credence to the notion that borrower tenure starts further along the seasoning ramp for refinance loans. refinance loans appear marginally faster than purchase money loans. However. 2005 Specified Pools: Superior Prepayment Profiles Offer Added Value III. in the form of a lower price. Figure 19 shows the difference in the drop and the incremental carry advantage for various prepayment speeds for a FNMA 5% MBS (a discount coupon with a dollar price of 98-25). 20 Moreover. For a discount coupon specified pool. The three variables in the roll analysis are the break-even finance rate.November 2. with superior prepayment characteristics. 21 and the prepayment speed. 2004. is based on dollar roll analysis. In this sense. the investor is also implicitly short a put option. a pool that pays at 30% CPR when the aggregate average is 40% CPR would have a one-tick advantage in carry for that month. extension protection for discount coupons. For example. 21 Citigroup Global Markets For an explanation of dollar rolls. faster speeds return par-priced principal to the investor more quickly than TBA. July 1. In this case. investors would have to wait longer to receive some of the principal cash flow than they expected and they would be unable to invest it at the prevailing higher rates. The MBS investor. In other words. Carry-Based Valuation The traditional method of computing the carry advantage from owning a specified pool. due to its superior prepayment behavior. Each has advantages and disadvantages. For a premium coupon specified pool. see Dollar Rolls — In Practice and Theory. that they get for buying an 20 MBS relative to an option-free bond with the same nominal coupon. they can prepay slower than expected. 21 . conversely. slower prepay speeds erode the desirable premium coupon paid to the investor more slowly than TBA collateral. relative to the cash flow that they expected based on their prepayment assumptions when they originally purchased the MBS. we can determine the value of the prepayment speed differential between specified pools and TBA by comparing the drops for the different prepayment speeds. Borrowers have the option to prepay at any time without penalty (with the rare exception of prepayment penalty mortgages). the drop (difference between the front-month and back-month prices). By using the market rate for the break-even financing rate and varying the prepayment speed assumption. The Bloomberg Roll Analysis calculator compares the difference between holding a pool and selling it into the roll. Specified pools afford prepayment protection for premium coupons and. While borrowers cannot increase their loan balance at the existing note rate when market rates rise. The premium that the investor receives for “selling” the call option is the discount. is worth more than a generic TBA is simple enough to understand on a conceptual basis. Specified Pool Value: Enhanced Returns Through Superior Convexity The notion that a specified pool. in the case of fully seasoned paper. Citigroup. Figure 18 shows the difference in the drop and the incremental carry advantage for various prepayment speeds for a FNMA 6% MBS (dollar price 102-04). We cover both in the following sections. is explicitly short a call option. But how much is the difference in prepayment speeds worth? Two common methods for determining the value of a specified pool relative to TBA are carry-based valuation and OAS-based valuation. we can see how the drop changes. they have had a put exercised against them. 50% pool (dollar price 103-08). the carry advantage is cumulative. 23 22 A 12-tick pay-up divided by 1 tick per month equals 12 months. each month that the specified pool prepays slower than the TBA adds to the carry advantage. Finally. The most common method for expressing the relative value of specified pools using OAS is to use a constant OAS as a benchmark to calculate a theoretical price for the specified pool. Citigroup Global Markets . the investor will earn the pay-up back in 12 months. the carry difference for a 10% CPR change in prepayment speeds is 1½ ticks from 60% CPR down to 50% CPR and 1¼ ticks from 50% CPR down to 40% CPR. FNMA 6% Carry Advantage by CPR One-Month CPR (%) 10 20 30 40 50 60 Back-Month Price Drop Incremental Carry Advantage 102-01+ 102-02:2 102-03:1 102-04:1 102-05:3 102-06:7 05+ 04:6 03:7 02:7 01:5 00:1 00:6 00:7 01 01:2 01+ NA Back-Month Price Drop Incremental Carry Advantage 98-20:7 98-20:6 98-20+ 98-20:3 98-20:2 98-20 04:1 04:2 04+ 04:5 04:6 05 NA 00:1 00:1 00:1 00:1 00:2 NA Not applicable. For example. if we look at a FNMA 6. This makes it possible to estimate the payback period for a market pay-up.November 2. Figure 19. the carry advantage estimated from the roll is the advantage for one month.00% pool. if a specified pool with a 6. The difference 22 The carry advantage is also greater for pools that are further from par. 2005 Specified Pools: Superior Prepayment Profiles Offer Added Value Figure 18.23 After that. Because the advantage is cumulative. For example. OAS-Based Valuation The other main method of valuation is OAS-based valuation. FNMA 5% Carry Advantage by CPR One-Month CPR (%) 5 10 15 20 25 30 NA Not applicable. The OAS of the TBA is used as a proxy for the specified pool. the carry difference for a 10% CPR drop in prepayments from 50% CPR to 40% CPR is 1¾ ticks compared with the 1¼ ticks for the 6. relative to purchasing a TBA. Source: Citigroup. The tables show that the carry advantage is larger when the overall rate of prepayment is faster. Source: Citigroup.22 Furthermore. For the premium coupon.00% coupon has a 12-tick pay-up and prepays at 30% CPR when the overall aggregate average is 40% CPR. any advantage in prepayment speeds represents profit on the trade for the investor. so a specified pool that pays at 40% CPR when the overall aggregate average is 60% CPR has a 2¾-tick carry advantage. Source: Citigroup. Investor Pct.000 $125. The TBA price plus the market pay-up is used as the price to calculate an OAS for the specified pool.3 4.42 -2. State Pct.” 25 Daily specified collateral valuation reports are available on FI Direct: Origination Year Report to Swaps on manifold MB712.3 21.5 20.4 19.79 -1.8 20.00% 6. The investor can then directly compare the OAS of the TBA and OAS of the specified pool. and the Z-spread for each specified pool. 24 Mo. the option cost. 24 It is also possible to compare OASs. and implied pay-up (using constant OAS). 2005 Specified Pools: Superior Prepayment Profiles Offer Added Value between the theoretical price of the specified pool and the market price of the TBA is 24 the theoretical. pay-up.93 1.6 4. Loan Balance Avg. We used the generic TBA attribute values for all attributes except the specified attribute listed in the table.06 1.0 14.88 2. NA Not applicable.9 3. The OAS of the specified pool (even with the market pay-up included in the price) is generally higher than the OAS of the TBA because of its superior prepayment profile. Property Pct.78 -2.88 2. the theoretical price. Loan Balance Inv.0 21.1 29.9 4. 25bp 100% 100% 102-04 103-11:2 102-28:7 102-15:5 102-17:2 102-12:1 102-02 102-00 102-04 99-04:6 102-10:4 102-04 102-17:6 NA 39:2 24:7 11:5 13:2 8:1 -2:0 -4:0 0:0 11:6 6:4 0:0 13:6 4.61 Z-Spread (bp) 98 76 84 92 88 90 98 90 105 73 100 98 101 85 63 71 79 75 77 85 77 92 60 87 85 88 a The fully seasoned pool is compared to a FNMA 5.4 20.70 2.19 -2. Figure 20.78 -2.48 -2.8 25.000 703 77% 50bp 42% 13% -13bp Source: Citigroup.0 4.07 2.3 17. 25 effective convexity.4 13. Citigroup Global Markets 23 . The difference between the OAS of the specified pool and the OAS of the TBA is known as an “OAS pickup.57 -2.5 Effective Duration 1.0 23.00% TBA Attributes Attribute Value Coupon WAC WAM WALA Loan Balance FICO LTV Servicing Spread Refinance Pct.8 4. Specified Value Theoretical Price Implied Pay-Up WAL NA $65. FICO LTV Servicing Spread WALA WALA Servicing Spread Purchase Loan Pct. Note: New York is run assuming a $227.0 3.50% 343 Months 15 Months $167.32 2. long-term CPR.000 loan size and two-month WALA.13 2. See report on manifold MB707.2 4.2 6. Stipulated Attributes Report on MB721. one-year CPR.59 2. Figure 21. Market pay-ups are typically not as high as theoretical (implied) pay-ups because of various factors that we discuss below. Generic FNMA 6.0 35. Loan Balance Avg.2 4. The table also shows the weighted average life (WAL).2 20. and Model Payups for State Specific Pools on MB707.8 26.1 11. the effective duration.44 -2. calculated for a price of 102-04.7 16. Figure 20 shows attributes for a generic FNMA 6.000 $95.0 4.91 1.000 100% 600 90% 100bp 0 Mo.94 2.31 3.7 27.91 2.November 2.2 21.8 29.7 4. Figure 21 shows the specified value for various attributes.00% TBA with a price of 98-25.7 23.91 2.6 28. or implied.65 -2.00% TBA pool including the OAS.9 17.2 18.6 One-Year Long-Term CPR (%) CPR (%) 29.60 Effective Option Convexity Cost (bp) -2.68 1.9 18. Theoretical Prices and Implied Pay-Ups for Individual Specified Attributes Specified Pool Specified Attribute TBA LLB MLB HLB Investor Low FICO High LTV High SATO Low WALA Fully Seasoneda Low WAC Purchase New York NA Avg. OAS (@102-04) 6. 10 83 70 NA Not applicable. ⅞ The implied pay-ups for high LTV and high SATO are negative.5 29. and the numbers after the colons are eighths of a tick.7 year longer and the bond is less negatively convex.5 10.). ⅜ 26 The theoretical prices and implied pay-ups are listed in trader notation. The other specified pools follow a similar pattern. Loan Balance Servicing Spread Avg.08 -2.59 2.6 years with the one-year CPR at 23. Loan Balance Servicing Spread WALA FICO LTV Servicing Spread NA $65. etc.88 2. However. LLB pools prepay considerably slower as the WAL extends to 4. The table shows that some combinations are worth more than the sum of the individual attributes. Its WAL extends to 4.9 17.2 15. 2005 Specified Pools: Superior Prepayment Profiles Offer Added Value The most valuable specified pool is LLB. Of course. The units for the numbers before the dash are points. suggesting that they prepay faster over the life of the pool. with low-FICO and high-LTV pools prepaying faster than the overall aggregate averages.27 The high-LTV and high-SATO pools have weighted-average lives that are less than TBA.2 3. the next most valuable pool is the MLB pool.000 0 Mo. Loan Balance Avg. As noted.7 18.000 25bp 0 Mo.99 82 69 104-00:7 60:7 6. credit-related stories that were valid during the refinance wave of 2003 have turned around since then.5 8.34 -1. FICO. indicating that the models value these pools at less than the TBA pool.5 29.17 -1. the LLB and low WALA combination has an implied pay-up of 47 ticks.8 36. By comparison. Theoretical Prices and Implied Pay-Ups for Selected Combinations of Specified Attributes Specified Pool Specified Attribute Specified Theoretical Value Price TBA LLB LLB w/Low WAC NA Avg.9 1.23 98 76 76 85 63 63 103-19:3 47:3 5.0 21. 600 90% 100bp LLB w/Low WALA LLB w/Low WAC & Low WALA Credit Impaired Implied Pay-Up WAL One-Year Long-Term CPR (%) CPR (%) Effective Effective Duration Convexity Option Cost (bp) Z-Spread (bp) 102-04 103-11:2 103-20:6 NA 39:2 48:6 4. which has an implied pay-up of 39¼ 26 ticks. Source: Citigroup. 27 From the model’s perspective.6 3. the numbers after the dash are in ticks (32nds of a point). the TBA pool has the aggregate average for specific attributes (average loan balance.November 2.3 20.96 80 67 101-31:6 -4:2 2.78 -2. Loan Balance WALA Avg. Figure 22.9 5. no one would sell a pool for less than TBA. Low-WALA pools sometimes command a modest pay-up in the market only for pools with a WALA of three or less.19 -2.71 -2. The duration is about 0. The table shows low-WALA pools with no implied pay-up.8% CPR. Why is the total implied pay-up for the combination of LLB and low WALA worth more than the sum of the individual pay-ups for LLB and low WALA (39¼ + 0 = 39¼ ticks)? Part of the explanation is that Yield Book® recognizes that the seasoning ramps for different loan sizes are different.7% CPR.7 2. however. For example. LTV. as noted.000 $65.0 years) and the one-year CPR drops from 29. they would simply deliver the pool into a TBA trade.9 years (from the TBA value of 4. $65. Figure 22 shows implied pay-ups for a few combinations of specified attributes. which has an implied pay-up of 24 ticks.000 25bp $65. 24 Citigroup Global Markets . a low WALA can enhance the value of other specified attributes.4 12.0% CPR to 21.2 14.0 4. the slope for LLB is gentler than the aggregate average.000 instead of the generic TBA average of $167. the second line shows the value added by having a loan balance of $65.000 that is also 100% investor properties. Figure 24 shows the waterfall of specified attributes layered on top of each other. That extra value is recognized when we inform the model of the 28 lower WALA as well. 29 For example. 28 Simply put. a LLB pool with a WALA of less than 3 is worth more than a LLB with a WALA of 15. Seasoning Ramps for In-the-Money Pools (0bp–100bp) by Loan Size Category LLB 35 MLB All 30 CPR (%) 25 20 15 10 5 0 0 6 12 18 Age (Months) 24 30 36 Sources: CPR and CDR Technologies. We listed specified attributes in the order of their 29 individual value from Figure 21. The ramp for LLB is below that for the overall aggregate average. The next line shows a pool with a loan balance of $65. Figure 23. graphically showing the prepayment advantage.000. Further. Each subsequent line represents the addition of that specified attribute to the previous ones. The differential between the two ramps is increasing and peaks at about 10%–12% CPR CPR around 12–15 months before narrowing to a long-term differential of about 5%–8% CPR. Using Yield Book affords a better understanding of the effects of interactions between security attributes. while removing inconsistent values. The difference in the seasoning ramp for LLB adds extra value beyond what our prepayment model predicts based on the pure loan balance effect alone. 2005 Specified Pools: Superior Prepayment Profiles Offer Added Value Figure 23 shows the seasoning ramps by loan size category in 2005.November 2. For example. Citigroup Global Markets 25 . a pool cannot simultaneously have a low WAC (with a servicing spread of 25bp) and the high-servicing-spread characteristic of credit-impaired pools (100bp). Inv. turning a premium coupon pool into a discount coupon pool.000 100% 600 25bp 0 Mo. the investor is paying 2 ticks less than breakeven for the repurchase in the back month (i.2 14. which may last longer but is not guaranteed. if the drop is trading 2 ticks above carry. If the implied pay-ups seem too high compared with current market pay-ups. at which point the prepayment protection can cease to exist.49 -2. In particular. 90% NA 102-04 103-11:2 103-16:3 103-15:6 103-25:2 104-02:3 104-07:2 104-11 NA 39:2 44:3 43:6 53:2 62:3 67:2 71:0 4. The attributes are LLB and 100% investor properties.5 6.4 6. Over this time frame.59 2. potentially stretching into years.7 21. because there is uncertainty regarding the recovery of the pay-up. Also. For example. market conditions can change to make the differential in prepayment speeds less than expected or less relevant from a relative value perspective. effective durations can differ from observed market durations. Loan Balance Inv Property Pct.9 5. Investors hedging specified pools sometimes pick a duration between that of the TBA and the duration given by a model for the specified pool.88 2.5 6. Low WAC.9 12. Beyond model projection errors.. When rolls are special. the prepayment model can be wrong. In general. reducing the implied pay-up. an investor selling into a dollar roll would pay less to repurchase the TBA in the back month than indicated by the current market financing rate and the market’s consensus for prepayments.7 18.9 29.06 -2.19 -2..69 2. Low WALA NA $65. Source: Citigroup. 2005 Specified Pools: Superior Prepayment Profiles Offer Added Value Figure 24.2 16. such as supply shortages or heightened demand for collateral for CMOs. earning 2 ticks of additional carry). The difference in speeds predicted by the model may not materialize.0 21. Theoretical Prices and Implied Pay-ups for a Waterfall of Specified Attributes Specified Pool Specified Attribute Specified Value Theoretical Price Implied Pay-Up WAL One-Year CPR (%) Long-Term CPR (%) Effective Duration Effective Convexity TBA LLB Investor Low FICO Low WAC Low WALA High LTV Best Combination NA Avg. In other words. combined with low WALA and low WAC (servicing spread).4 12. the value of specified pools declines because investors can earn additional carry via the roll. A low FICO and/or high LTV actually make prepayments faster. model LLB effective durations are often substantially longer than durations implied by market price moves. For example.23 3. the carry is locked in. The investor must then choose between guaranteed carry for as long as the roll remains special and the carry advantage from specified prepayment protection. 26 Citigroup Global Markets .November 2.0 4. FICO Servicing Spread WALA LTV Loan Size. Pct.02 -2. because the back 30 month price is determined at the time of the roll. The recovery period for a specified pay-up can be many months. Most importantly. Because the theoretical prices given by the model are often different (usually higher) compared with market pay-ups.e.70 2. Rolls usually become special because of technical factors. if the implied pay-up is 20 ticks and the market pay-up is 10 ticks.0 21. rates can change.8 12.” which is the combination of attributes that provides the largest implied pay-up.4 11. Prop.84 Option Z-Spread Cost (bp) (bp) 98 76 74 73 73 77 75 76 85 63 61 60 60 64 62 63 NA Not applicable. Moreover.11 -1.3 11.” A roll is considered special when the drop is trading above carry.78 -2.23 3.0 4. The last line shows the “best combination.7 20. the roll could become “special. that’s because they are.9 17.0 7.00 -2.7 1.82 3. an investor might use a duration that is midway between 30 Investors can earn additional carry via the roll when it is special.7 17.08 -2. market pay-ups not are as high as theoretical pay-ups.9 5. Source: Citigroup. Figure 25 provides a summary comparison of the carry-based and OAS-based valuation methods. Figure 26 shows projected prices for LLB and TBA conventional 6. The differences can be thought of as theoretical specified pool payups to TBA. Scenario Analysis — What If Rates Move? Looking at multiple interest rate shift scenarios can be useful for both the carrybased and OAS-based approaches.November 2. rate shift scenarios should reveal where the value of the specified pool comes from. it can be difficult to know how much certain rate scenarios are contributing to the theoretical price and implied pay-up without additional analysis). As an illustration of the use of scenario analysis. In the case of OAS-based valuation. Accounts for changing rates via changing prepayment model projections and logical from a theoretical perspective. estimating the duration of the specified pool based on recent rate and price movements in the market. but it is also very model dependent. Dependent on having prepayment model and OAS model. rate shift scenarios provide an illustration of the impact of rate moves that is missing from the traditional base case carry analysis. and not clear that applying the TBA OAS to the specified pool is correct. this method has the advantage of taking into account changing rates. Comparison of Carry and OAS Valuations Which method of assessing the relative value advantage of specified pools is more accurate? Carry-based relative values are easy to understand but assume that the environment doesn’t change. so ignores how specified pool advantage may be affected by rate moves. Advantages Simple and intuitive — only need nearterm prepayment projections and can compute “breakeven” number of months for earning back specified pool pay-up. Neither method accounts for the loss of liquidity when moving from TBA to a specified pool (and the potential loss of advantageous roll opportunities). an OAS model is in some ways a “black box” — it is not always obvious where the value of the specified pool is coming from (in other words. Need prepayment model. Disadvantages Assumes stable rates. an investor might use an “empirical” duration. Because OAS models average valuations over a spectrum of interest rate paths. OAS valuations are only as accurate as the prepayment model projections. Further. Citigroup Global Markets 27 .00% pools in a range of interest rate scenarios. 2005 Specified Pools: Superior Prepayment Profiles Offer Added Value the model durations for the TBA and specified pool for hedging purposes. Comparison of Valuation Methods Criteria Carry-Based OAS-Based Pricing Assumption Constant pay-up/price TBA OAS Prepayment Projection Requirements Need near-term prepayment projections. In the case of carry-based valuation. along with price differences. Figure 25. Alternatively. Figure 27.4 8.00% pools.00% Pools Immediate Rate Shift Scenario Projected Long-Term Projected CPRs (%).00% LLB TBA Difference -300bp -200bp -100bp 0bp +100bp +200bp +300bp 106-00 103-28 2-04 105-11 103-00 2-11 104-30 102-22 2-08 103-11 102-04 1-07 99-23 99-01 0-23 94-31 94-19 0-12 89-24 89-19 0-05 Source: Citigroup.4 31.7 -0. the speed advantage of LLB 6.1 7. LLB and TBA 6. Because LLB provides protection against refinancings.00% Pools Constant OAS Immediate Rate Shift Scenario Projected Prices and Differences. However.9 71. 13 Sep 05 Close Scenario FN 6. 32 At this point.4 10. Citigroup. TBA 6.00% pools are so far in the money that further drops in rates have little impact on projected speeds. In this scenario. The scenario pay-ups are as one might expect. the bulk of the value of LLB 31 comes from rate rally scenarios. March 2004.November 2.4 0.9 -3. the LLB advantage reaches a maximum in the -200bp scenario. 31 It follows that an investor who believes rates will increase would tend to value LLB less than others who do not have a view on rates or expect rates to fall. and the implied pay-up follows suit. speeds of LLB 6. (Figure 27 shows projected scenario speeds.1 Source: Citigroup. although rallies tend to enhance the value of LLB.7 10. which are at lower levels than TBA speeds. In other words.4 72.5 45.00% LLB TBA Difference -300bp -200bp -100bp 0bp +100bp +200bp +300bp 53.) As a result.2 -20. can continue to increase as rates decline. 28 Citigroup Global Markets .32 In contrast. the relative value of LLB collateral generally increases as rates decline and refinancings increase. See Anatomy of Prepayments — The Citigroup Prepayment Model.3 52.9 -19.2 20. speeds have essentially reached their maximum level.0 8. 13 Sep 05 Close Scenario FN 6.3 -25.6 7. LLB and TBA 6.9 17. 2005 Specified Pools: Superior Prepayment Profiles Offer Added Value Figure 26.5 -0.00% pools can be seen to decline as rates decline from the -200bp to -300bp scenario. seasoned collateral was actively traded. 3 Changing market conditions. Less value in rolls translates into greater value in specified pools. may result in changes in the prepayment behavior of certain specified categories. leading to investment opportunities. many other collateral characteristics have been identified as providing added value to investors. 2 In recent months.November 2. there have not been many dollar roll opportunities. possibly creating opportunities in highLTV/low-FICO premium coupons. This more detailed data may provide additional ways in which to identify value. if home appreciation weakens significantly. highly-leveraged borrowers take advantage of strong home price appreciation. non-third-party originations and condominiums might exhibit favorable prepayment behavior. such as a weakening of the currently strong housing market. but. highLTV and low-FICO collateral has been prepaying relatively fast as these less affluent. Conclusion Specified pool trading has long been an important sector of the mortgage market. There is good reason to believe future opportunities in specified pools will arise: Citigroup Global Markets 1 Interest in specified pools naturally grew after the agencies increased their pool level disclosures in 2003. for example. 29 . Freddie Mac recently announced that it would begin providing loan level data for its newly issued pools in the near future. In the 1990s. However. 2005 Specified Pools: Superior Prepayment Profiles Offer Added Value IV. loan size has tended to dominate specified pool trading. this collateral will likely slow substantially. For example. as described in this paper. In recent years. and only make such decisions on the basis of the investor's own objectives. and may have interests different from or adverse to your interests. or one of its affiliates (collectively. “Citi”). Citi often acts as an issuer of financial instruments and other products. Citi's personnel (including those with whom the author may have consulted in the preparation of this communication).Disclaimer This communication is issued by a member of the sales and trading department of Citigroup Global Markets Inc. 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