Conventionals vs. Governments (Figure 1) • The turmoil
at Fannie and Freddie over the summer eroded investor confidence.
The conventional-government OAS widened to 20 bps and remained roughly
at that level. Interestingly enough, mortgage current coupon rates
(MTGEFNCL vs. MTGEGNSF) have been just 4-6 bps apart, but the steep
curve is detrimental to the value of Ginnies that prepay more slowly.
Freddies and Fannies have traditionally been priced in complete
unison. They are 2-5 bps apart now - assuming identical prepayments.
Premiums (Figure 2) • With the same concept
(OAS = compensation for prepay risk), we can explain the dynamics
of premium MBS. When rates drop, their prices exhibit visible "compression",
i.e. prices do not rise as the constant-OAS Duration predicts. For
example, FNCL7.5 has been priced in a narrow range between 106 and
107 - regardless of the rates. Correspondingly, OAS "absorbs"
all rate moves and is far from being constant.
This is a low blow to the OAS theory, but its extension,
prepay-risk-and-option-adjusted valuation (prOAV), explains many phenomena.
Since higher coupon MBS are fragile, they should be progressively
discounted for bearing the refinancing risk. This puts a limit on
practical price appreciation. The same theory explains dynamics of
IO/PO/MSR pricing; we expect prOAV and the related risk-adjusted spread
measure, prOAS, to become hot topics in 2004.
Figure 2. OAS for premium FNCLs
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