How MBS Traders Think

Here is a very interesting piece on how Wall Street mortgage backed securities (MBS) traders and analysts think. I included nearly the entire research write-up here, leaving the firm off of it, as it touches on many subjects that loan agents, Realtors, whoever, don’t think about very often, but this type of quantitative analysis directly impacts the rates that loan agents and consumers see each day:

“Although dollar prices of Fannie 3.0’s (these securities would include 3.25% and higher mortgages) have skyrocketed over the past few days, there has been very limited originator selling of this coupon. Below we try to estimate at what price spread level of Fannie 3.5s/3.0s swap, originators should have an economic incentive to move new issuance into Fannie 3.0s from Fannie 3.5s.

Let us say that a lender has originated $100 mortgages at 3.9% mortgage rate and is deciding between securitizing them in FN 3.0s or FN 3.5s. He has got two options:

(A) Create $100 FN 3.0s and retain 90bp servicing spread, or

(B) Create $100 FN 3.5s and retain 40bp servicing spread.

At Friday’s closing price levels, in Option A, he gets $101 cash and retains 90bp servicing spread. In Option B, he gets $103.1 cash and retains 40bp servicing spread.

Which one of these options is better for him?

Right now, 2010 FN 3.5s IOS is trading at 17-02. Since the 2011 IOS should trade somewhat better than 2010 IOS, let us assume that the 2011 3.5s IOS is worth $19 and also that the servicing asset trades at about 15% discount to IOS (fairly realistic assumptions).

In this case, the 50bp additional servicing in Option A versus Option B is worth: (0.5/3.5)*(19*0.85) = $2.31.

Thus, the originator gains $103.31 ($101+$2.31) by following Option A versus $103.1 by following Option B in a completely liquid market with no barriers to trading.

In other words, as long as the FN 3.5s/3.0s swap is below $2.31 (2-10), the originator should create FN 3.0s instead of FN 3.5s (from a purely economic perspective) while this swap was trading at about 2-04 at Friday’s closes.

Of course, originators need to set aside capital if they retain excess servicing – so they may need some premium over what is indicated by economics to move into FN 3.0s instead of FN 3.5s.

And the Basel III constraints on the contribution of MSRs to bank capital are also possibly making originators reluctant to keep excess servicing spread on their balance sheets at the moment.