PrimeX Primer; Broker Business Still Impacting Prepayment Speeds; Shouldn’t Mortgage Rates be Lower?


note: occasionally there is too much news information to stick with the
usual Monday-Friday commentaries. And thus we have today’s. Sorry to intrude on
any quiet Sunday out there, but what are you doing checking e-mails
today anyway?)

At the end
of last week a leading Wall Street researcher wrote, “The general tone at
ABS East was somewhat gloomy, however most participants view the non-agency
sector relatively attractive versus other sectors. The market has seen a recent
drop in PrimeX prices, and it is
important to understand the collateral underlying in the Prime index and
factors that will drive the future performance of the underlying borrowers as
well as the cash-index basis.” What
the heck does that mean?

everyone has heard of the Dow: even a grade-schooler could tell you, “If
it goes up, that means the stock market is going up, right?” But it only
measures 30 stocks, thus the SP 500, which includes 470 more, is a better
measure but is less quoted in mainstream media for some reason. Does the
mortgage-backed security market have equivalents? Yes, one being the “Markit PrimeX,” which is a
synthetic CDS index referencing a basket of prime mortgage-backed securities.

When it was launched its intent was to “to create a liquid, trade-able
tool allowing investors to take positions on prime mortgage-backed securities
via CDS contracts.  Its liquidity and standardization will allow investors
to accurately gauge market sentiment around the asset-class, and to take short
or long positions accordingly.” So instead of buying $500 million of
different MBS securities, one could buy a piece of this synthetic index, and
more information can be found here.
Or, if you really want to hear more, visit here,
and click on the photo of the gal who will give you a lengthy lecture on the
whole thing – thanks Josh F. (The internet is an amazing thing.)

These derivatives, somewhat understood by those in the mortgage biz and finance
community but not at all by the rest of the world including protesters, have
become a bad word. But I bring all this up because these PrimeX derivatives tied to jumbo loans are plummeting in a divergence
from the underlying bonds
“as firms from TCW Group to Wells Fargo say
the credit-default swaps are sending false signals.” The prices, per a
story in Bloomberg, have “reached record lows this month as trading
quadrupled. One index tied to fixed-rate debt fell 10.6 percent through
Tuesday, while the underlying bonds declined less than 1 percent, Markit Group
Ltd. and JPMorgan Chase Co. data show. Hedge funds that don’t usually
trade mortgage debt are piling into PrimeX swaps, seeking the kinds of fortunes
that investors earned in 2007 betting against subprime loans, JPMorgan and
Barclays Capital analysts said. Trading in PrimeX contracts, whose prices move
lower as the cost of protection against defaults on so-called jumbo mortgages
rises, soared to $1.2 billion in the first week of October, about the same as
in all of September…” When indices diverge from the actual securities to
which they are tied, someone typically makes a lot of money and someone is
going to lose a lot. “About 12 percent of jumbo mortgages in securities
are now at least 60 days delinquent, according to Amherst Securities Group

can use them to hedge mortgage production. It
is easy to argue against this practice, but traders can also use Treasury
securities to hedge mortgage pipelines. But one runs the serious problem of
basis risk: one security’s price/rate moving while the other does not
. During
the past week, production coupon 30-year pass-throughs have lagged 5-year and
10-year Treasuries by about .125 in price, but higher coupon 30-year MBS and
15-year MBS have outperformed both their Treasury hedges and lower coupon
30-year MBS over this period. The Fed purchased $5.85 billion agency MBS’s over
the one week period ending October 19, while domestic bank holdings of agency
MBS have increased by $12.9 billion over the week ending October 5.

mortgages yields have backed up close to 50 basis points from the start of the
month, the Fed is buying over $1 billion MBS’s per day, the refi index is off
20% from recent highs, and new-production mortgage supply is falling
(applications are down). So mortgage
rates must be great for borrowers, right?  Not exactly: mortgages have had
trouble getting out of their own way of late as volatility has increased,
investors are spooked (notice the Halloween reference!) due to the uncertainty,
once again, about the government’s refi program.
Besides, any originator
can tell you even if mortgage rates were 1% a good portion of borrowers could
not refi anyway. (CoreLogic estimates that about 53% of borrowers with equity
in their homes are paying above market rates (defined as the current rate plus
1%, or 5.1%) and higher. About 36% are paying more than 5.5% and 17% are paying
more than 6 per cent – think of the refi possibilities!! And about 8 million borrowers
who owe more on their homes than they are worth, or about 75 per cent of all
“underwater” homeowners, are also paying above-market rates.)

After the
Fed announced it would invest early pay-offs back into MBS’s, day-trading
investors were forced into the market after the mortgage rally and “we now find
them a) kicking themselves and b) sitting on the sidelines waiting for better
entry points to bring down the cost of their panic purchases.” By the various
reports I have seen, most folks want to be on the same side as the Fed: buying

But mortgage rates for borrowers are
running half a percentage point higher than recent historical averages would
suggest, complicating Federal Reserve efforts to boost economic growth.
Since 2000, rates for 30-year
mortgages in the US have generally been about 1.5% higher than yields on
10-year Treasury securities. Earlier this year, the spread between the two
rates narrowed further, touching a low of 1.28% in February. A week or two ago,
however, the average 30-year fixed-rate mortgage in the US had a rate of 4.18% which is nearly 2.0% higher than the 10-year
Treasury yield!

It is one
thing to say mortgage rates should be
lower; it is another to actually have them there. The spread between US
mortgage rates and the 10-year note widened during the summer as investors
bought Treasury debt as a safe haven amid growing fears about the European
financial crisis. The start of “Operation Twist” in September – in which the
Fed buys longer-dated Treasuries to push down long-term interest rates, and
then buying mortgages, has caused spreads between mortgage rates and government
debt to narrow, but not enough to return the relationship to its customary

Lenders say they are charging relatively
higher mortgage rates because of tighter lending standards, falling home prices
and a lack of capacity to process new home loans, all of which have increased
. And the Fed can’t mandate
that, right?
Heck, if an underwriter can only get through 2-3 files a day,
of course! The number of mortgage brokers has shrunk by two-thirds since 2006.
So many companies are keeping the extra spread for themselves. One analyst from
Deutsche Bank said, “Higher prices and lower rates on [mortgage-backed
securities] only get passed along to consumers at the discretion of mortgage
originators, and those originators seem happy keeping rates right where they
are.” And thus the big lenders don’t
seem very interested in competing on rate

Those in
the production trenches know that third-party/broker/TPO loans are originated
by brokers and correspondents (as opposed to a brick-and-mortar retail arm). And
we know that the role of brokers is to advise borrowers, take applications and
help select a lender. (Correspondents take the next step as they are able to
fund and close a loan in their own name.) For both channels, the servicing is
released to the investor. In addition, loan officers are paid solely on commission.
As a result, TPO loans are solicited aggressively to refinance at every
possible opportunity, and a research piece from Barclays notes the resulting sharp
increase in prepayments relative to retail loans when newly in the money.

Should it surprise anyone that broker
loans pay off more quickly than retail production?
First off, the broker is not dead: a
study of recent higher prepayments showed that faster speeds in lower coupon
4/4.5s caught the market by surprise, leading many participants to increase
their expectations for new production collateral. However, a closer look shows
a strong TPO effect for newer loans (2010-11) which explains the majority of
the increase. Barclays recommends “investors find call protection in low TPO%
and loan balance pools.”

October report, in our view, is evidence that the TPO effect is alive and
kicking. While the TPO effect fades over time, it could still be a strong prepayment driver in
the coming prints. In particular, newer WALA and high balance pools could be more reactive
to rates in today’s environment. We recommend investors looking to insulate themselves
from this effect to consider the following: pools with a low percentage of TPO-originated
pools – we recommend investors pay close attention to the TPO%, particularly
for new WALA pools. We also recommend that investors pay attention to the loan
balances in the pools: We believe the loan size gradient for TPO loans could
steepen further from here as the changes to broker compensation filter through
the market. As a result, we believe loan balance pools also provide more call
protection than in the past. In addition, for lower loan sizes, there is no
difference between retail and TPO loans. As a result, investors looking for
loan balance and TPO protection for a cheaper pay-up should consider HLB pools.”

To sum things up, the good news for
brokers is that news of their death is greatly exaggerated. The bad news is
that investors are nervous about buying loans originated by them due to the
faster-than-average early pay-off risk, and this can certainly impact pricing.

discretion advised.)

cute little girl, missing her two front teeth walks into a pet store. The owner
looks at her and says “may I help you”?

The girl
looks up and says, “Id wike to buy a bunny wabbitt”.

The store
owner smiles and says, “Would you wike the pwetty little bwown one or the
cute widdle whie one”?

The girl
looks at him and says, “I don’t think my python gives a thit””

If you’re interested, visit my twice-a-month blog at the STRATMOR Group web
site located at . The current blog takes a look at
Fannie Freddie the FHFA, and the changes they have in the hopper.
If you have both the time and inclination, make a comment on what I have
written, or on other comments so that folks can learn what’s going on out there
from the other readers.

Leave a Reply