Valuation Commentary

Hybrids at a Glance
by Alex Levin

Many clients have explicitly expressed a desire to see hybrid ARMs as a part of our standard market analysis posted every Friday for fixed-rate conventional TBAs. We feel a genuine interest from investors in this sector. Whereas hedge fund managers always hunt for less traditional products with hidden value, banks routinely keep originated hybrid loans in their own investment portfolios. In short, we find that hybrids do offer an OAS above fixed rates, but with an interesting and complex dynamic to bear in mind.

Rich or Cheap?

In each of our tests, we employed the AD&Co valuation system operating with the 4.3.3 prepay model that almost all of our clients use. We used 2000 paths of quasi-Monte-Carlo and a single-factor Hull-While model. As I mentioned at the 13th Client Conference and in the February Pipeline, using the two-factor model presents no sizable contribution to the pricing of hybrid ARMs. In Exhibit 1, we use today’s OAS levels for new hybrids (red line) into a historical retrospective. As shown, the hybrid market has tightened from last summer, but, as we know, so has the fixed-rate market. To compare with the TBAs, we report current-coupon LOAS for FNCLs as +12.3 bps (August), -3.8 bps (January) and -3.0 bps (July) – on the matching market dates.

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