Breaking Down the Relationship Between MBS Markets and Loan Pricing

Introduction

There are a multitude of factors that work in tandem to determine how mortgage pricing is determined and what products lenders can offer borrowers. In these subsequent pages, this paper will expand on the relationship between consumer loan pricing and capital market conditions while addressing some of the common misconceptions of how loans are priced. It will also illustrate the process involved in generating consumer loan offerings and intermediate loan prices.

In short, mortgage backed security (MBS) market prices are incorporated with multiple other factors to value alternative execution options. Once able to determine “best execution”, lenders will calculate the prices at which loans will be offered to consumers, and the prices that correspondent lenders will pay for loans originated by smaller primary lenders. While it can be useful to contemplate the impact of MBS and mortgage spreads on primary loan offerings, spread levels aren’t incorporated into loan pricing methods. Rather, MBS prices combine with a few other factors to drive loan valuations and consumer loan pricing.

This document will examine how these processes work and will demonstrate how the various factors interact with each other when generating loan pricing. These insights are important in understanding the process of generating loan offerings and the factors that drive changes in consumer mortgage rates. The data in this document is sourced from a piece titled The Links Between MBS Markets and Loan Prices written by Bill Berliner, Director of Analytics at MCT—a capital markets advisory firm based out of New York. 

Common Misconceptions

The relationship between consumer loan pricing and capital market conditions is commonly misconstrued within the mortgage industry. One misconception is that mortgage rates are dictated by rate spreads. Loan pricing methodologies can’t directly utilize the MBS spread or any such output to generate their mortgage rate matrices. It’s more accurate to view changing MBS spreads as a coincidental result of the relative performance of MBS and Treasury prices rather than as a major driver of mortgage rates.

Additionally, there is a common misconception that lenders offer consumers ‘rates’. It is important to note that lenders do not directly generate or offer rates. Rather, they calculate and offer prices for a given range of note rates. This concept is vital to understanding how mortgage rates are generated.

How is Consumer Loan Pricing Calculated?

The methodology used to generate consumer loan prices utilizes a combination of inputs and factors. Pricing for fixed-rate loans is typically calculated for a range of note rate strata centered around a perceived rate level.

There are two primary steps necessary to generate loan pricing:

• Determine the best-execution coupon for each note rate level

• Calculate the all-in price at each rate either as a price or as discount points paid by/credited to the borrower

The examples that we’re using utilize 30-year conventional loans. It’s also helpful to keep the economic structure of the mortgage market in mind. Pricing derived from securitized execution is the standard for which pricing at other levels is derived.

Cash Flow Allocation of Loans

Before we dive into the nitty gritty of coupon-best execution, we’re going to review the allocation of a loan’s cash flow within an MBS. All of the principal is paid to the bondholders while the borrowers’ interest payments go to three different destinations:

• Servicing: When you’ve provided a loan to one of your clients, you’re pretty much done with the loan itself (keep developing that relationship with your clients though!). But someone’s got to ensure that the loan is paid and that the funds are sent to the right places. That’s where the servicer comes in. They’re not going to do all of that work for free, so mortgage securitization programs stipulate that ‘required’ servicing is held to compensate them for their work. 

• Guaranty Fee: You might also know these as “g-fees”. These are payments made to an agency such as Ginnie Mae, Fannie Mae, and Freddie Mac in exchange for providing credit support for the issued security. For around the last decade, g-fees hover around 45 basis points for UMBS, and this is the figure we’ve used in our examples.

• Pool Coupon: Fixed-rate MBS are almost always created with coupons. In even 50 basis point increments. The coupon rate is the interest paid to the holder of the MBS based on the remaining principal value of the security.

UMBS pooling rules specify that the note rates of loans must be at least 25 basis points above the security’s coupon rate and at most 112.5 basis points higher than the pool’s coupon. This means that every note rate can be pooled through two possible pool coupons. When pooled down, the cash flows from the loan are allocated to required servicing and g-fees, which may result in some excess servicing. When pooled up into the higher allowable coupon, there usually isn’t enough interest to cover the required servicing and g-fees. Therefore, some or all of the g-fee must be “bought down” or remitted to the government-sponsored entity (GSE), such as Fannie Mae or Freddie Mac, as a lump-sum payment when the pool is created.

Figure I demonstrates how cash flows for a conventional loan with a 3.375 rate can be allocated using the methods explained above. As you can see, when assuming 25 basis points of required servicing and a 45-basis-point guaranty fee, pooling up into a UM 3.5% passthrough results in a shortfall of 32.5 basis points. In this case, the g-fee shortfall must be bought down by paying a lump sum to Fannie Mae or Freddie Mac. The amount of the payment is calculated using a buy-down multiple provided to the securitizing lender by the GSEs. For example, if the multiple quoted is 5x, the 32.5 basis points buyout equates to 1.625 points on the par value of the loan and is paid directly to the GSEs.

Pooling down into a UM30 2.5% passthrough leaves 17.5 basis points of excess servicing in this figure. In this case, the GSEs might buy the excess interest at a lower multiple. For example, if Fannie quoted a 4x multiple, they would pay the lender 0.7 points to purchase the cash flow.

FIGURE I: Cash Flow Allocation for a Loan Being Slotted Into UM30 2.5% and 3.0% Pools

From time-to-time, GSEs facilitate the pricing process by providing approved MBS issuers with “Buy-up/Buy-Down” grids which display the multiples at which the buy-up or buy-down transactions can be executed. Figure II is a hypothetical example of a buy-up/buy-down grid for a 30-year fixed-rate mortgage with note rates shown in 12.5 basis point increments and multiples shown for a range of remaining maturities.

Buy-up and buy-down multiples typically decrease as note rates increase—this reflects the negative impact of faster prepayments on the value of interest-only cash flow streams.

Figure II: Hypothetical Example of a Buy-Up/Buy-Down Grid for 30-Year Fixed-Rate Mortgages

Calculating Coupon Best-Execution

The first, and generally the most important step when generating loan pricing for each note rate is to calculate its optimal execution. In other words, the MBS coupon rate that generates the maximum proceeds from securitization. Figure III shows a hypothetical example of the process for a loan with a 3.375% note rate.

Based on current pooling rules, the loan can be pooled into either a UM30 2.5% or 3% pool. When pooled through a 2.5% pool, the loan creates 17.5 basis points of excess servicing which can either be sold or retained. The 3% pool requires buying down 32.5 basis points of the g-fee. Based on the example figure, it would indicate that pooling down into the 2.5% pool offers better execution by approximately half of a point.

Figure III: Coupon Best-Execution Example

This example shows that there are multiple inputs and assumptions that drive analysis. Some of the key factors include:

• The price of the two TBAs. The dollar prices in figure 3 differ by 1 and 14/32nds. Expanding on this ‘coupon swap’ would tend to push execution towards the “pooling up” scenario.

• The level of the “g-fees”. Although a 45 BPS assumption is consistent with industry standards, it’s important to note that prior to 2010, g-fees were about half of their current levels. Higher g-fees mean that “pooling up” into the higher coupon requires more of the g-fee to be bought down. Because buy-down multiples are typically higher than buy-up multiples, higher g-fees will typically skew the execution toward pooling down.

• The levels of the buy-up and buy-down multiples. As noted, Figure 3 indicates that 32.5 basis points of the g-fee needs to be bought down if the loan is pooled into the 3s, while 17.5 basis points of excess servicing are created by pooling into 2.5s. As a result, both the absolute and relative levels of the multiples impact execution. For example, if both multiples are increased to 4.5x, the execution advantage of pooling into 2.5s increases to 81 basis points; decreasing both multiples to 2.5x makes UM30 3s the best-execution option by about 19 basis points.

While Figure 3 displays the value of required servicing to convey the concepts of g-fee shortfalls and excess servicing, it’s important to note that the amount and value of required servicing doesn’t change for the different coupons and in turn, doesn’t impact the execution. Margin and expenses also don’t impact the best-execution calculations since they don’t vary based on the execution.

The calculation has also been simplified for conventional loans by the Single Security Initiative. Previously, best execution often needed to be established with both Fannie Mae and Freddie Mac as pooling options. The creation of a single UMBS security makes it unnecessary.

Conclusion

This document illustrates the processes involved in generating consumer loan offerings and intermediate loan prices. Mortgage pricing is determined by inputs including MBS prices, servicing valuations, guaranty fee levels, and buy-up/buy-down pricing provided by the GSEs. Lenders exercise the most control over their profit margins, which they use to tweak their profitability and control their volumes during periods of heavy origination activity.

As part of its dedication to provide its Loan Originators with top-of-the-line resources, UMortgage has a dedicated Capital Markets team which keeps its finger on the pulse of the market and assists our LOs and Operations team throughout the loan origination process. If you're interested in this or any of the other ways that UMortgage is helping its LOs amplify their business, sign up for the weekly Discovery Call, which happens every Thursday at 2pm EST.