The Interaction of MBS Markets and Primary Mortgage Rates

Abstract

The determination of mortgage rates results from a complex interaction of capital market pricing, the costs associated with credit enhancement, and the valuation of the servicing asset. The actual rate determination process relies on the calculation of the optimal security coupon, based on information from the capital markets, which is then used to determine the points associated with a given rate. Using this process, points for a range of note rates can be determined to generate a rate/point grid, allowing consumers to manage their loan costs by trading off points and rates. The process of determining optimal execution and generating a rate/point grid for conforming-balance loans often involves comparing credit enhancement and servicing costs for both the agency and the private-label market sector. In fact, agency and private-label execution served as competing securitization options for many periods between 2002 and 2006. The cost of credit enhancement is valued differently in the agency and private-label markets. Agency credit costs are a function of the guaranty fees quoted by the government and quasi-government agencies for various products and attributes, and are converted into present-value terms by various methods, including multiples quoted by the agency in question. The cost of private-label credit enhancement is a function of both the amount of subordination required and its pricing, and translates directly into price terms. Therefore, the choice of agency versus private-label execution is often a function of the factors influencing buydown multiples, which in turn are dictated by the same factors that drive servicing and IO valuations. Through the process known as “ risk-based pricing,” lenders augment the individual loan program’s rate/point grid with “ add-ons” to account for the idiosyncratic risk associated with unique obligor and loan characteristics. Add-ons are often converted in a rate premium for borrowers unable or unwilling to pay the incremental closing costs associated with the add-ons. <b>TOPICS:</b>MBS and residential mortgage loans, CMBS and commercial mortgage loans