Value Commentary

Recent events at Fannie Mae and Freddie Mac including "excessive portfolio risk at Fannie Mae and the accounting turmoil at Freddie Mac" (see link) have reduced investors' confidence in the creditworthiness of the pass throughs backed by these agencies. Figure 1 shows the spread of the conventionals' current-coupon yields to Ginnie Maes. At first glance, it seems that the spread widened throughout June when the scandal at Freddie broke, but has been narrowing ever since. Perhaps investors' confidence in the agencies is returning.

Figure 2 paints a different picture, however. This chart illustrates the differences between the current-coupon OAS (the interpolated OAS on a theoretical par coupon) on the conventionals to Ginnie's. This shows the spread trending upwards beginning in June and continuing through August. How can the OAS spread be widening while the CCY spread is narrowing? The answer is that the yield curve has been steepening, leading to a steeper forward curve. Because conventionals have a shorter average life due to their faster prepayment speeds, a steeper curve widens the OAS for these pass-throughs and makes them cheap relative to Ginnies. When looked at on an OAS basis, it is clear that investor confidence in the Freddie and Fannie is declining rather than increasing.

Figure 3 corroborates this conclusion. This chart shows the spread between Fannie Mae 10Yr maturity debt and comparable 10Yr constant maturity treasury. The upward trend in the spread began in June and continued through the first half of August. A closer look has revealed that our initial impression was incorrect, and agencies are cheapening from an objective view. >>>