Specified Pools and Pay-Ups

Most agency mortgage bonds trade "to be announced," or TBA — a buyer agrees on price, coupon, and settlement date without knowing exactly which pool of loans they'll receive until just before settlement. The seller can deliver any pool that meets the contract's minimum eligibility rules, and sellers naturally deliver whichever pool is cheapest for them to give up. That gives every TBA buyer the worst pool available at that price, in expectation — which is exactly why a buyer who wants better prepayment behavior has to step outside the TBA market and buy a specified pool by name, usually at a pay-up over the TBA price.

Why some pools prepay slower, and are worth more

A mortgage pool's expected prepayment speed depends on details TBA trading ignores: the average loan balance (small loans prepay slower — refinancing a $60,000 loan barely saves enough in dollar terms to bother), geographic concentration, how seasoned the loans are, and whether the loans came from a bank known for slow-refinancing borrowers. A buyer holding a premium-priced MBS (one paying an above-market coupon) loses money every time a loan prepays, because the principal comes back at par instead of continuing to pay that above-market coupon. That buyer will pay up for a pool specifically flagged as low-balance or otherwise slow-prepaying, because slower prepayment protects the premium they paid.

Worked example

A 6% coupon TBA is priced at 102 (i.e. $1,020 per $1,000 face). A specified pool of the same coupon, but made up entirely of loans under $85,000 in balance — historically slow to refinance — trades with a 24-tick pay-up, at 102-24 ($1,027.50 per $1,000 face). A model prices that pay-up by estimating the pool's expected prepayment speed at, say, 8% CPR versus a TBA-average 14% CPR, running both cash-flow streams through the model at the market's current OAS, and finding that the slower-prepaying pool's extra retained coupon income over its life is worth roughly $7.50 per $1,000 of face value more than the generic pool — matching the quoted pay-up.

What this means in practice

Pay-ups are a direct, tradable expression of prepayment expectations: they rise when refinancing incentive is high (because slow-prepaying pools become relatively more valuable) and shrink toward zero when rates are far from any borrower's incentive to refinance, since prepayment speed barely matters to anyone at that point.