Valuation Commentary

Prepayment-risk-and-option-adjusted-spread Valuation
by Alex Levin

What is the difference between the risks embedded in agency MBS and agency debentures? Why are MBS usually traded at a wider spread, even on an OAS (Option Adjusted Spread) basis, i.e. after the prepayment option exercise is accounted for? Why are agency IOs traded "cheap," at an OAS in the hundreds, sometimes over one thousand basis points, whereas same-credit, same-pool POs are "rich"-- trading well below agency bonds on an OAS basis. Finally, why do the effective durations that are derived using the constant OAS method rarely match empirical durations (a nightmare for risk management practitioners)?

All of these issues are addressed by a new valuation approach developed by AD&Co., which is rooted in Capital Asset Pricing Model (CAPM) and its extension, the Arbitrage Pricing Theory (APT). According to this new approach, the OAS results from the risk of the prepayment model being wrong or biased. Moreover, the risk is two-dimensional and includes fears that a model understates refinancing (refinancing risk) and overstates turnover (turnover risk). Therefore, the prepayment risk is associated with "prepayment variability" only to the extent left unexplained by a prepayment model, i.e. beyond the interest rate effect.

Our approach states that after accounting for the two (or more) main risk fears, all agency MBS (including strip derivatives and CMO tranches) should be priced flat to debentures. We call the new spread measure prepayment-risk-and-option-adjusted-spread (prOAS). We would price all agency MBS at zero prOAS using the appropriate agency curve (FNMA or FHLMC) as the benchmark. Since we employ the swap curve instead, we should account for the appropriate agency-swap spread. For example, the MBS pass-through and its IO/PO strips carved from 5.5% collateral should have the prOAS roughly equal to the spread between agency and swap computed for maturity matching the forward-curve average life of that collateral. In the actual agency market, this spread usually varies narrowly between negative 20 to positive 10 basis points, whereas the traditional OAS measure can vary between negative hundreds of basis points for POs to positive one thousand and more for IOs. Since POs can be used as hedges against the refinancing risk, they are penalized rather than rewarded - in line with the APT. This is to say that the risk is directional and does not always lead to a price concession. >>>