Valuation Commentary

Insights into Historical Current Coupon OAS
By Alex Levin in Collaboration with Andrew Davidson & Anne Ching

When investors attempt to assess how attractive the mortgage market in general is, there exists no better measure with which to begin than the OAS for the current-coupon TBA. This OAS is often found and reported versus the swap rates ("Libor OAS" or LOAS), but the measure taken off the agency debt curve is also informative. A systematic, though volatile, difference between expected returns on agency MBS and agency debentures is a point of investor interest. On the other hand, it serves as the source of income for the U.S. agencies that are the major MBS investors, themselves, holding about 30% of the market (Perli and Sack [2003]). Nevertheless, this positive spread is not a free lunch, it compensates for prepayment risk (even after prepay option exercise is modeled) and operational risk although small differences in liquidity and credit quality exist as well. Let us briefly review these sources.

Risk factors

Prepayment risk. A large portion of prepayment uncertainty is associated with interest rates and, as such, explained by prepayment models that are inherent to modern OAS analytical systems. If prepayments were perfectly explained by a model, then there would exist little reason for "prepayment risk premium": an option model coupled with a "perfect" prepayment formula should be able to deliver the right price for an agency-backed (default-protected) MBS operating with OAS = 0. An MBS would be valued flat to a known benchmark curve - similarly to swaptions, just with a more complex exercise rule.

Savvy market participants realize that a model can tell only part of the prepayment story. A model's inability to predict prepayments exactly causes unexplained deviations of prepayment speeds above or below the model's forecast, often termed "prepayment surprises" or "prepayment errors". We associate the notion of prepayment risk with this uncertainty unexplained by an unbiased prepay model and assume that the OAS compensates for this risk. AD&Co. maintains a two-dimensional view of prepayment risk: the risk that a model overstates the turnover speed (turnover risk) and the risk that it understates the refinancing speed (refinancing risk). Correspondingly, both premium MBS (exposed to refinancing) and discount MBS (exposed to turnover) should be priced at somewhat elevated OAS levels. This two-risk-factor theory explains well the phenomena of IO/PO pricing too, but what about the subject of our interest, the current-coupon MBS? >>>