Value Commentary

The Impact of Age on Valuation

The assumption made about the age of collateral in TBAs can have a large impact on the valuation of these securities. We have run OAS analysis on FNMA TBAs with 5% and 8% coupons to examine the impact of age on the valuation of premiums and discounts (while 5s are not technically discounts, they are as close as we can get in the current environment.)

Consider figures 1 and 2 (seen on the next page), which show the original balance of FNMA loans originated in different quarters (data provided by CPR/CDR). We have run our OAS analysis assuming different ages corresponding to peaks in origination on these charts. For the FNMA 5s, we chose the peaks at the 3rd quarter of 1998, the 3rd quarter of 2000, the 4th quarter of 2001, and the 3rd quarter of 2002. For the FNMA 8s, we used the peaks at the 4th quarter of 1993, the 3rd quarter of 1996, the 2nd quarter of 2000, and the 1st quarter of 2002. Though there was not a large amount of origination of 8s in the 1st quarter of 2002, there was some, and this quarter was included for illustrative purposes.

Tables 1 and 2 (seen on third page) contain the results of our analysis. It is clear that the age assumption has a large impact on valuation, especially for the FNMA 8s. As age rises from 11 to 32 months, our burnout assumption changes and prepayments slow, causing OAS to rise from 22 to 102 basis points. OAS continues to rise as age increases from 32 to 77 months, but it levels out as age continues to increase because the collateral has already experienced the full impact of burnout. If we were to continue to increase our age assumption, we would see OAS begin to decline as our average life decreases.

Discounts show the same effect, but for an entirely different reason. Changes in age do not produce a significant change in prepayments, but a higher age leads to a faster recovery of principal and thus a higher OAS. If our age assumption declines from 110 to 11 months, our duration is extended and our OAS drops from 126 to 22 basis points. These results are illustrated in Figures 3 and 4 (seen on third page).

In conclusion, age has a significant effect on valuation. When valuing TBAs, in which the age of the collateral is unknown, it may be a good idea to run your analysis with several different age assumptions and choose the most conservative valuation measure. >>>