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    From the desk of Joel Banes September 2019           

       download: Joel Banes' Jewels and Pools

What drives the SBA market? Obviously, it’s the investors who pay the most for the product. It is crystal clear that the largest buyers of SBA loans have consistently been forming par pools. This means that the poolers are creating interest-only investments known as Certificate of Originator Fees “COOFs.”

What is so attractive about these COOFs? Let’s consider the economics of investing in COOFs. 

 

Example

The current bid price is 116.73 for a 25-year full coupon loan with a pass-through rate of Prime +1.075%.

In order to create par pool with a coupon of Prime Rate -2.60% (2.65% coupon based on 5.25% Prime Rate as of 8-1-19), it takes a 4.7 strip ratio.

The COOFs’ bond equivalent yield (BEY) using a 4.7 strip ratio at various Constant Prepayment Rates (CPR) are:

CPR

BEY

    Average Life  

 Treasury Yields

       Spread

 

 

            (years)

(4/15/19)

 

12%

 5.93%

      6.54

1.50%

+443

13%

 4.81%

      6.16

  1.48%

+333

14%

 3.68%

      5.81

1.47%

+221

15%

 2.55%

      5.49

1.43%

+112

16%

 1.40%

      5.19

1.43%

-3

 

Keep in mind that strips come from pooled loans, and as such, have the same prepayment speed as the underlying par pool.

At what prepayment speed would a sophisticated investor take 100% prepayment and default risk?

In this example, the COOF investor would pick up 333 basis points at a 13% CPR and 443 points at a 12% CPR. Given the July vectored CPR for a new 25-year pool of 12.4% (21yr+ WAM) one appears to be well compensated for taking on the prepayment risk. However, the treasury yields were approximately 100 basis points higher until recently.

These full-coupon 25-year loans were trading at an approximate price of 116.375 in the middle of April. The appropriate strip ratio would have been 4.6.  

CPR

BEY

    Average Life  

  Treasury Yields

       Spread

 

 

            (years)

(4/15/19)

 

12%

6.41%

        6.54

2.46%

+395

13%

5.25%

        6.16

2.42%

+283

14%

4.09%

        5.81

2.41%

+168

15%

2.92%

        5.49

2.40%

+52

16%

1.74%

        5.19

2.38%

-64

  

On April 15th, the spreads at 12% and 13% CPRs were 395 and 283 basis points respectively. However, if one used a 14% CPR the pickup in yield was only 168 basis points, at 15% a mere 52 basis points, and at 16% an investor would lose 64 basis points. 

 

Given that the market has held up at these prices, it is apparent that COOF investors are betting on prepayment speeds staying under a 13% vectored CPR. At higher speeds, these investors simply aren’t compensated for taking on the risk.

The converse should be true as well. Investors looking at new premium pools with a 21yr+ WAM want to be sure that they are being properly compensated for premium risk based on the latest vectored CPR. The current vectored speed for August is 12.5% based on Bloomberg SBA prepayment speeds (PSBA).

Those are my thoughts. Always happy to discuss.   

JOEL BANES (901) 261-5950