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Events of 2003
In May of 2003 the rates fell to their 40-yr record; refinancing panic dominated the MBS market. In the AD&Co. model, interpolated CC LOAS widened to 27 bps, but premium MBS were at a progressively wider spread (http://www.ad-co.com/secure/market_analysis/2003/qa-5-30-2003.html). On the same day, Trust IOs got dramatically reduced to single-point values; OAS levels exploded to 1000 - 1500 bps. Consider MSR managers and hedge fund IO investors. They used the TBAs to hedge their assets and ended up getting hammered in both places. Sure, they hedged the basis risk out and may even have had the false sense of being in calm waters, except their basis risk model missed a major point: prepay model risk.
The prOAS Angle View of the Basis Risk
According to our view, a material portion of the basis widening and tightening can be attributed to the market's prepayment revisions and changes in the price of prepay model risk. These events are most likely the result of a sudden large (long unseen) change in interest rates, but may also be associated with other economic indicators, such as new home sales, economic trends and home prices. It is the relative position of the current MBS rate and the outstanding MBS stack that drives the risk.
If rates drop, the outstanding MBS volume will be at a premium, clearly triggering refinancing concerns. In such an event, the current-coupon MBS will widen in recognition of potentially more aggressive (and efficient) exercising of the prepay option. However, this widening of the MBS basis may affect other instruments completely differently. Premium MBS should widen to a much greater extent, IOs may be hammered whereas discount MBS won't be affected. This is what happened in 2003.
If rates rise quickly, the outstanding mortgage volume will find itself
at discounts leading to concerns about the speed of housing turnover.
Here, many may be surprised to learn that the current-coupon MBS will
widen again - this time in recognition of potential losses caused by
a slow turnover if the sellout continues. Of course, this widening will
be leveraged in discount MBS and POs, but not in the premium MBS or
IOs. In fact, IOs should tighten because they can be viewed as hedges
against slowing turnover. In exhibit 1 we show a recent, but rather
typical, prOAS calibration diagram with two major principal components
of prepayment risk (red line, pink line).
