The specified pool market (“Specifieds”) offers execution benefits for all mortgage sellers, whether you directly securitize, sell to the agency cash windows or to aggregators via mini-bulk. Specifieds offer pay-ups based on loan characteristics that result in slower prepayment than similar TBA trades that lack those characteristics. Origination margins have continued to compress due to tight market conditions and historically high cost to originate. In response, some aggregators have been more aggressively passing through specified pool pricing to gain or maintain market share, offering significant pay-ups to sellers based upon certain loan characteristics. Lenders can benefit by passing through some of the extra margin to loan officers, they can use it to pad margin, or they can do a little of each.
When taking advantage of this market opportunity there are risks that to be managed:
- Do not under-hedging loans that may be eligible for specified pay-ups when committed. Typically, specified pools have longer durations than their underlying TBA counterparts. The Specified market thrives because these pools provide an extra layer of prepayment protection for which investors will pay a premium over TBAs. As rates rise, the demand for this protection decreases, therefore Specifieds will worsen in price relative to the underlying TBAs. The opposite occurs in a rally – as rates fall, there is greater demand for prepay protection, leading to an increase in pay-ups and a price gain in Specifieds that will be larger than for underlying TBAs. Ignoring the longer duration inherent in the specified market can lead to increased hedge costs. Compass recommends using an appropriate duration metric for the Specified-eligible products in order to properly match TBA hedges, thereby avoiding the risk of under-hedging.
- Avoid marking loans to be delivered to Specifieds to a vanilla execution. Marking to a vanilla (or TBA) execution can lead to day one mispricing and gain/loss volatility. If one is marking loans to a TBA execution yet locking based upon Specified pricing, loans will come in underwater on day one. When selling, this practice may also lead to a disconnect between an earlier MTM price and the commitment price, causing large gains to show in G/L day over day. Pricing to an appropriate Specified pay-up will eliminate the risk associated with mispricing.
Compass has been sourcing Specified pay-ups from broker/dealers, Compass-traded pools and aggregators providing clients with pay-up marks for MTM purposes that help avoid G/L disconnects. Compass also provides durations for Specified stories in order to better match notional amounts of TBA hedges to Specified products in pipelines. While pay-up levels may vary across sellers, especially for those securitizing, it is still appropriate to us specified pay-ups which are driven by duration and market color for daily marks. The pay-ups Compass provides may not reflect each individual seller’s experience in the Specified market, but they are a defensible, market driven proxy that may better reflect the risk and G/L changes associated with Specifieds.