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Valuation Commentary
Is the MBS Market Expensive?
by Alex Levin
Investors looking for MBS opportunities quickly come to the conclusion that the market is “expensive” in general, as witnessed by a stream of negative Libor OAS levels reported by major brokers. This may look abnormal to some investors who expect the MBS market to offer additional return over simpler fixed-income instruments. In this short article, we show that the MBS market is where it should be, given historical levels, agency rates and apparent stability of interest rates. In our view, the market is a self-learning system that, in the absence of big events, “learns itself” and reduces compensation for bearing the prepay model risk. Yet, we see some opportunities in the premium (burnt) coupon sector and related IOs.
Historical levels of LOAS for the Current-Coupon
Levin [2001] studies the 1995-2000 history of Libor OAS for the current-coupon FNCL TBAs and finds it is typical to stay within a negative 20 to 0 basis point equilibrium1. Only when the international financial system came close to the global crisis (1998), did the spreads temporarily widen.
The widest LOAS levels after 2000 were seen in May-June 2003 after rates dropped to their 40-yr record lows. See the next exhibit for the last 2.5 year history2.
1 Using an OAS system developed for The Dime Bancorp.
2 Using the AD&Co OAS system (generation 5).
