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Valuation Commentary - June '06
The MBS Basis
Risk
by
Alex Levin
MBS basis risk is the risk of a widening or a tightening of an MBS spread to the swap (agency, Treasury, etc) benchmark curve. The most common measure of the basis is either the nominal spread or the OAS reported for a current-coupon MBS. In my opinion, the latter is the preferred measure as it removes an indirect volatility effect.
It is widely perceived that MBS investors are willing to bear mortgage-specific
risk without quantifying it or hedging. This practice is now becoming
less and less feasible. Vanilla products don't yield much over non-MBS
notes, whereas mortgage derivatives are loaded with prepayment risk.
Therefore, quantifying the risk and considering hedging is necessary
to identify truly cheap instruments and "lock into OAS." Let
us consider how the basis risk comes into the hedging game and how fundamentally
the concept of prOAS (AKA prepay risk-neutrality) alters the traditional
view.
Traditional View of the Basis Risk
According to the traditional view, hedging against the basis risk simply requires taking a delta-neutral position to the MBS spread to the benchmark curve. Hence, an IO or MSR investor is advised to add a long TBA (or similar) hedging position to the portfolio. If the MBS market rate tightens to swaps (with all else unchanged), the IO would lose due to prepay acceleration, but the gain of the TBA will offset the loss.
It does not matter what causes the basis tightening. Aside from the apparent prepayment effect, in some analytical systems, basis widening or tightening can have a direct additive or subtractive affect on the OAS of other MBS. The rationale behind this view is that the "entire mortgage market" widens or tightens. For example, agency OAS widening for the current-coupon TBA can follow accounting scandals of other credit events and, as such, should be propagated to other TBAs and agency MBS. In essence, the OAS level for the current-coupon MBS is employed as the starting point for the OAS of other MBS.
