Valuation Commentary
The Lessons of an Eventful Year
By Alex Levin & Jay DeLong

In 2003, we saw interest rates plunge and surge -- an ultra-steep curve, accounting turmoil at Freddie and excessive portfolio risk at Fannie. Mortgage rates dropped to a 40-year record-low of just above 4% in June only to quickly rise by over 150 bps. Multi-billion dollar pools were running off at 70-75 CPR, frightening investors and making MBS look hazardous.

Dynamics of OAS
Par Coupons (Figure 1) • Since OAS for mortgage instruments is earned for bearing prepayment risk, it tends to widen when investors fear the worst. According to our OAS model, in mid-June current-coupon conventional TBAs were priced at a Libor OAS level approaching 50 bps (40 bps for GNMA). After the summer's refinancing wave cooled, OAS numbers began to level off. With the rates seemingly returning to their starting levels, OAS numbers are lower now than in January.

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