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Several explanations for agency MBS cheapening exist:
• Demand/supply imbalance – existing investors are forced to sell MBS assets to raise cash, meet margin calls, and maintain liquidity. Potential investors don’t have cash and face high cost of borrowing.
• Psychological effect that impairs liquidity – MBS are relatively complex fixed income instruments. Investors (especially, foreign) tend to avoid assets they don’t know well - even if they are not “those” mortgages.
• Modelers naturally like to keep their models under all circumstances, but they have to carefully revisit assumptions such as housing mobility, loan origination standards and home price appreciation, since they influence prepayments and may not hold in a stressed economy. Hence, some cheapening or richening can be illusive.
None of these reasons relate to GSE credit. In fact, the AD&Co. OAS model shows us that government TBAs are slightly cheaper than conventionals. The rest of the article contains analyses of major agency MBS sectors up to August 24, 2007.
Fixed-Rate TBAs
Exhibit 1 on the following page depicts the dynamics of the current-coupon (blue) LOAS over the last 6 months using AD&Co. the OAS system V7.2. On the same graph we show LOAS for two discount TBAs: FNCL 4.5 (pink) and FNCL 5.0 (red). On the right axis, we plot the risk-neutral turnover tuning over the same historical interval (green).
