barclays introduction to inverse io

8/9/2019 Barclays Introduction to Inverse IO

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Introduction to Inverse IO

Kumar VelayudhamAgency MBS/Derivatives Strategy 212-412-2099

February 17, 2009

Please see analyst certification(s) and important disclosures starting on page 19.


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Why look at inverse IOs

now?

Inverse IOs look the cheapest across mortgage assets

They carry no credit risk and have limited exposure to the slowing economy

Inverse IO yields shown above include the cost of hedging duration and convexity. Unhedged

yields are generally higher.

Security Loss Adjusted Yields

Super Senior Jumbo AAAs 8-10%

Super Senior Alt-A AAAs 13-15%

Super Senior Negam AAAs 14-17%Subprime Cash AAAs 13-15%

CMBS Senior Cash AAAs 13-14%

Consumer ABS - Auto 3Yr AAAs 7-8%

Inverse IO 20-25%


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Inverse IO basics: Cash flows and risks


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Creating an inverse IO

The inverse IO does not receive any principal, only the interest on notional

Inverse IO is equivalent to buying a synthetic premium with financing

Duration of floater ~0.

Inverse IO leverage ~107/7 =15

Pass Through

$100M, 6% CouponPO

$25M, 0% Coupon

Synthetic Premium$75M, 8% Coupon

Price = $107

Source: Barclays Capital. Prices shown are sample prices

Inverse IO

$75M Notional, $0 Principal

7%-L Coupon

Price = $7

Floater $75M Principal, L+1% Coupon,

8% Cap

Price = $100


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Cash Flows

Price of the strip Inverse IO ~ $5 to $10 for $100 notional

Coupon payment ~ (7% - 1mth Libor)

Coupon calculated on remaining notional amount

Inverse IO cash flows are dependent on prepayments & 1mth Libor

Cash flows depend on prepays.. …and prepays depend on rates

Source: Barclays Capital

0

50000

100000

150000

200000

250000

0 60 120 180 240 300 360

M o n t h

l y C a s h F

l o w

( $ )

10 CPR30 CPR

50 CPR

0

10

20

30

40

50

-200 -100 0 100 200

Rate Incentive Change (bp)

C P R

( % )


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Higher long-term rates benefit inverse IO

As rates increase, prepays decline and the average life increases, and vice versa

Longer average life implies longer stream of IO cash flow and, hence, higher yields

Inverse IO have negative duration to longer-term rates

In a backup, average life increases… …and so does the yield (ZV)


0

10

20

30

40

50

-200 -100 -50 0 50 100 200

Change in Rates (bp)

C P R ( % )

0

2

4

6

8

10

A v e r a g e L i f e ( y r s )

Average Life (yrs, RHS)

CPR (%, LHS)

20

30

40

50

-100 -50 0 50 100

10Y Rate Change (bp)

I n

v e r s e I O Y i e l d ( % )


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Other risks: Government intervention

Loanmodifications

Reappraisalremoval

Off-marketprogram

MBS purchase FED/Tsy purchases have lowered mortgage rates to historical lows

Persistent low rates can cause a refinance wave

FN/FH have instituted streamlined loan modifications

Increased moral hazard could cause involuntary prepays to increase

Removal of reappraisal requirements will increase callability

Unwind of agency fee/MI premiums will increase refinancibility

Government could institute an off-market 4.5% mortgage rate programThis would be the worst case scenarios for inverse IO valuations


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Valuing a sample inverse IO


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Bond details: What to look for

Bond summary (Cusip: 31282YE54, FHS 237 S22)Price* = $7-16

Coupon = 7.15% - 1mth Libor

Current coupon = 6.82%

Collateral summaryRecent speeds: 1mth CPR = 23.9%, 3mth CPR = 12.6%, life =8.2%

Prepay characteristics: GWAC = 6.03%, Wala: 34, Current loan size: 201,870

Credit characteristics: Average FICO: 729, average original LTV: 72%

* Indicative prices as of close on 02/11/2009


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Bloomberg yield table: Yield to forward


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Prepay and Libor effect: Yield to spot


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Yield analysis

Note: As of close on February 11, 2009. Source: Barclays Capital.

Yield to forward vs. CPR Months to outlay recovery

Yield analysis across prepay speeds is the most common valuation tool

Comparing breakeven CPR with current and estimated CPR provides a good benchmark

Estimating the months to outlay recovery is another tool – cash flows are front-loaded

-40

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0

20

40

60

80

0 10 20 30 40 50 60

CPR (%)

Y i e l

d t o F o r w a r

d ( % ) 1m, 24CPR = 43% Yield

Estimated, 30CPR = 33% Yield

Breakeven

Lifetime, 8CPR = 65% Yield

10

20

30

40

50

10 20 30 40 50

CPR(%)

M o n t h s t o O u t

l a y R e c o v e r y

Spot Libor

Forward Libor


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What drives inverse IO valuation?

The two main factors driving Inverse IO pricing are:

Strike on the inverse IO (Coupon = Strike - 1mth Libor)

The prepayment characteristics of underlying MBS collateral

Strike of inverse IO

Collateralcharacteristics

The higher the strike, higher the coupon and cash flows

Underlying product –

GN vs. FN, IO vs. conventional

Pool prepay drivers –

Loan balance, GWAC, geography

Borrower credit –

FICO, LTV

Structure –

Strip, PAC, support, sequential


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Choosing the right collateral

Conventional (TBA)

Seasoned

Ginnie

Mae

15yr

10/20 interest only

Low loan balance

Most callable as cheapest collateral is delivered

Burnout: Seasoning removes refinance-sensitive borrowers

Significantly weaker credit, but involuntary prepays are high

Faster pay-down leads to lower balance, but good credit;

shorter cash flows due to 15yr final maturity

High current combined LTV due to high % second liens and

high concentration in bad HPA states (CA/FL)

Fixed refinancing cost and lower cost savings$40 monthly savings for every 100bp rate difference

High LTV, low Fico Borrowers are credit constrained by MI premium, agency fees


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Prepayments across collateral: January 2009

Prepayments vary based on collateral characteristics

0

10

20

30

40

50

0 25 50 75 100 125Rate Incentive (bp)

P r e p a y m e n t S p e e

d , C P R

( % )

TBA"10-20GNMALLBHLBSeasonedHigh LTV/Low FICO

Source: CPRCDR, Barclays Capital


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Inverse IO valuation across collateral

The higher the prepay protection, the higher the price

Low loan balance (LLB) collateral offers the best protection, hence highest price

Bond Collateral Strike PricePx Multiple using

.45% LIBOR1-Mo Speed

(CPR, %)

Speed for 20%Yield to FWD,

(CPR, %)

Zero Yieldto Fwd

Multiple ofBreakeven to

Current Speed

FHS 246 S18 TBA 6.4 5.75 0.97 25 44 54 2.2

FHR 3303 SH 10-20 IO 6.43 7.58 1.27 14 33 45 3.2

GNR 07-59 SD GNMA TBA 6.47 5.25 0.87 41 48 58 1.4

FNR 07-30 LI LLB (85k MAX) 6.44 8 1.34 7 29 42 6.0

FHR 3274 SM HLB (150k MAX) 6.43 7.125 1.19 18 34 46 2.6

GNR 08-40 SA SEASONED 6.5 7.5 1.24 14 31 44 3.1

FNR 09-6 GS High LTV ,LOW FICO 6.55 7.12 1.17 13 36 48 3.7

MASTR 06-3 2A2 NON AGENCY MBS 6.5 7.5 1.24 23 30 41 1.8



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Positioning against forward: Inverse IO as a macro hedge

1mth Libor is dependent on fed funds rate and the level of economic growth

Market is pricing in a quick recovery relative to our forecast

Inverse IO valuations should benefit from slower recovery: macro economic hedge

Forward Libor rates Lower Libor will increase yields

0

1

2

3

4

5

0 10 20 30 40 50 60

1 M o n t h L i

b o r F W D

( % )

Current

Slower Recovery

10

30

50

70

90

10 15 20 25 30 35 40

Prepay Speed - CPR (%)

Y i e l d ( % )

Market Pricing

Slower Recovery



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barclays introduction to inverse io

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