Valuation Commentary

2005 Valuation Roundup: the Market and the Models
by Alex Levin

It has become a tradition to dedicate the December Valuation Commentary to a market round-up. After the eventful and volatile year of 2003, the MBS market has clearly stabilized. Stabilization has left fewer investment options to new buyers and has changed the flavor of the market. Our market analysis [based on the results of the AD&CO. OAS model version 6.0 and the Prepayment Model version 5.1 (“new model”)] offers a drastically expanded view of the market, which now includes the 15-years fixed MBS and 10 types of hybrids. We continued to run our “old model” (OAS version 5.2, Prepayment Model version 4.3) for historical consistency. Starting with the first Friday of 2006, we will stop reporting results obtained using the old model.

The curve continued flattening, rates went up, volatility came down

The swap curve continued its flattening trend that began in 2004. The 10-2 swap spread started the year at 115 bps and ended it at 11 bps. This effect alone should have made the mortgage market effectively shorter and inflicted value impairment to IOs and MSR due to higher forward prepayment rates. However, these usual consequences of flattening are compensated by a so-called “curve effect” built into the new prepayment model; it accelerates refinancing when the curve is steep and slows it down when it is flat.

The absolute volatility index that we introduced in June of 2003 started out this year at 97 bps and ended at 90 bps, but the entire drop occurred in January of 2005.

In terms of the MBS rates level, the first 8 months of the year were calm, but the fall saw rates surging by as much as 75 basis points. Although the rates came down somewhat, they remain high enough to have a visible pricing implication for the discount MBS sector (read below).

Finally, the swap spreads widened by as much as 23 bps (the 10-yr point); their term structure measured between the 2-yr point and the 10-yr point steepened by 15 bps.

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