14 Hoosier Banker November 2016 DIRECTORS / SENIOR MANAGEMENT About the Author Drew Simmons is vice president of The Baker Group and has been working in the field of finance since 2003. He works with community banks specifically covering interest-rate risk, asset and liability management, and fixed-income portfolio management. Simmons earned bachelor’s and master’s degrees from Oklahoma City University. The author can be reached at 800-937-2257, email: drew@GoBaker.com. The Baker Group is a Diamond Associate Member of the Indiana Bankers Association and an IBA Preferred Service Provider. Prepayments from September increased the most since the 2012 Refi Wave, the result of near lows in mortgage rates and a few more days in the day count for mortgage applications to close. As is typically the case as prepayments rise, demand for prepayment protection is on the rise. Investors in specified pools know all too well the benefits of low loan balance collateral as a form of prepayment and extension protection, but many are finding it difficult to stomach the relative “payups” associated with these pools in today’s market. As always, it boils down to a simple discussion of risk versus reward. Portfolio managers should avoid viewing any attribute of an MBS pool in isolation. For example, it’s no secret that higher coupon pools (compared to their lower coupon counterparts) offer far less price volatility in a rising-rate environment. However, we would be remiss if we simply focused our product selection on high coupon pools alone. When rates fall, higher coupon pools will have a larger incentive to refinance; therefore, investors should also seek out prepayment protection attributes to mitigate these risks. High coupon pools coupled with loans that have low loan balances, high investor/vacation mortgage loans, or HARP collateral have proven to provide the best forms of prepay protection. Figure 1 is a comparison of speeds in the universe of Fannie Mae 15year 4s with moderate seasoning (30-60 WALA). We’ve compared this cohort’s speeds (orange line) to FNMA AL6043, a 15-year Mega 4 percent specified pool (blue line) with 31 months of seasoning. The loans in the FNMA 15-year Mega have a max loan size of $110K, 43 percent of which are investor or vacation mortgages. Since the pool was originated in November, it has paid at an average 9.5 CPR. During this same time, its cohort has averaged about 4 CPR faster at 13.3 CPR. Figure 1 - Fannie Mae 15-year 4% Moderately Seasoned Speeds The prepay benefits of this 4 percent Mega pool come with a price in the form of a 109-5+ premium. At this level, with a projected 12 CPR, the bond yields 1.6 percent and 61bps of spread to a duration equivalent Treasury. You might be saying to yourself, surely there are cheaper bonds out there, and you’d be right. For example, a recently issued FNMA 15-year 2.5 has been trading at a much lower premium of 103-22 (FNMA AL8777). This has a slightly lower spread of 53bps, but an even better yield of 1.68 percent, assuming a 10 CPR. Prepay Protection - There’s No Free Lunch FIGURE 1
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