 |
 |
Valuation Commentary - Sept. '07
Agency MBS and AD&Co. Models during the Subprime Turmoil
by Alex Levin
In 1998 the financial world was stressed by a series of crises. Most notable, the Russian default in that August, triggered a chain reaction causing a number of large funds (like LTCM) to collapse, their counter-parties realized losses and everyone sought a safe harbor – U.S. Treasuries. All “spread products” cheapened drastically and, even on an LOAS basis, MBS widened to as much as 50 bps. LOAS for the current-coupon TBA came back down to 20 bps in about 3 months and in 3 more months, returned to its long-term normal range (-20 bps to +10 bps) where it had remained most of the time. I documented these dynamics in Fabozzi’s Professional Perspectives on Fixed Income Portfolio Management (2001).
One lesson we learned is that the agency-backed products can cheapen in the absence of an adequate cause directly related to the credit of that GSE. Another lesson is that LOAS levels are strongly mean reverting and tend to return to their long-term equilibriums. Under stress, market prices are not martingales and some mark-to-market losses are recoverable. In a good review of recent events, “Re-evaluating Valuation” (Risk, August 2007), Jayne Jung attributes losses occurred at Bear Stearns Asset Management (BSAM) to inability to meet margin calls, collateral seizure and its subsequent sales at a large discount that pushed prices further down. Bear Stearns stopped the process by a large cash injection.
Let us return however to my primary themes: Why would a credit crisis affect benign agency MBS? Does the AD&Co. agency model adequately reflect recent market changes?
