Valuation Commentary - September '06

Valuation Consequences of the New ARM Prepayment Model in v5.2a
Part I: Agency Hybrids
by Alex Levin

AD&Co has just released the new prepay model family for ARMs, version 5.2a. As a result, we are going to answer many questions, make all the due disclosures, and publish related documents. Pipeline readers seeking a systematic description of the new prepayment model can find that in our ADCo Update section. Those who want to learn how the new version will affect the OAS system should read on.

The Tail’s Alteration
The new ARM model is built in the way that is consistent with our fixed-rate model family. In particular, any pool is considered as a composition of two sub-pools (active and passive), the key feature driving the burnout process. Burnout does not stop after the 1 st reset and will continue to affect the prepayment behavior. This is very much unlike the old model where the post-reset speed was frozen for the entire loan class. Since hybrid ARMs reset to the same fully-indexed rate (the actual post-reset rate can be constrained by reset collars), it is the original GWAC that makes the difference. Pools with higher original GWACs get burnt faster and will have a slower post-reset speed and a higher value of the tail (Exhibit 1).