Q. Have we considered various CMO tranches for prepay risk assessment and calibration?

A. One important point to recognize about prepay risk-adjusted valuation is that the risk is located in a prepayment model, not in the CMO structure. The cash distribution rules are set in stone for every deal. Therefore, a particular CMO tranche should bear no additional wisdom of how the market regards prepayment risk or risks. I do not mean that all tranches should be priced at the same OAS as their collateral. We know that the collateral risk is amplified in an IO and dampened in a PAC affecting their OAS levels accordingly.

It is possible that some CMO tranches are practically priced in disparity with the collateral, which means an arbitrage opportunity.

Q. Have we accounted for liquidity differences? How does the prOAS method work for illiquid MBS or non-agency MBS?

A. The prOAS measure differs from the traditional OAS in that it accounts for prepayment risk. An appropriate liquidity spread should be added to the "perfectly liquid" prOAS level, which is the agency debenture level. Any credit adjustments should be made too. In accounting for imperfect liquidity or credit, the prOAS method and the OAS method share the same recipes. In particular, our Trust IO analysis has been performed using a 25 bps prOAS in recognition of the impact of liquidity.

Q. Is the discovered IO - TBA disparity a typical anomaly of the MBS market? Or, is it a once-in-a-life arbitrage opportunity?

A. In the paper and during the talk I pointed out that the TBA market clearly shows the risk of faster refinancing and slower housing turnover whereas the Trust IO market looks at prepayment risk as a single-dimensional source of risk. The prOAS valuation with prices of risk calibrated to TBAs do a decent (at times, stunningly accurate) job in predicting prices of the IOs, without consideration of the turnover risk. This fact leads to an arbitrage opportunity: combining a discount MBS with a discount, similar-pool, IO we hedge out the prepay risk while earning positive OAS off both positions. On August 29, 2003, Trust IOs were several points cheaper (200-300 bps wider) than the prOAS theory thought they should have been. >>>