Valuation Commentary

2004 Valuation Round-up
by Alex Levin

Last December, the year-closing article was titled "The Lessons of an Eventful Year". This year did not warrant such an adjective - it was quiet and stable. However, stability has implication in financial markets - it reduces the value of risk and makes risky instruments (read: MBS) expensive. Hence, the MBS market did generally well, but left fewer investment options to new buyers and changed the flavor of the market.

The curve is flatter and the rates are less volatile

With the overall rates staying roughly where they were (Exhibit 1), the swap curve flattened considerably. The 10-2 swap spread started the year at 255 bps and ended it at 115 bps. This change alone has made mortgage market effectively shorter by 0.1-0.2 years and caused value impairment to IOs and MSRs. The absolute volatility index that we introduced in June of 2003 (http://www.ad-co.com/newsletter/Jun03/Value.htm) started the year at 120 bps and ended below 100 bps.

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