Default Adjusted Spread (DAS)

Within MBS credit markets, credit enhancement levels have changed dramatically in recent years, reflecting the developing credit performance of the various loan types that collateralize subordinated MBS. Under such dynamic conditions, the static yield spread measures most commonly applied to evaluate subordinated MBS provide little information regarding changes in the net returns available from subordinated MBS after expected credit losses. Return measures such as OAS, typically applied to measure the cost of options such as the MBS credit option, have yet to evolve popularly within the market for lower rated MBS. Consequently, the expected returns available within subordinated MBS markets, after adjusting for credit losses, are not as visible as desired.

Andrew Davidson & Co., Inc. has developed a simple loss adjusted return measure called Default Adjusted Spread (DAS). DAS is similar to an OAS conceptually and is useful for gauging the expected returns available from subordinated MBS after credit losses, across ratings and collateral types. A useful feature of DAS is that it can be measured relative to each investor's cost of capital reflecting their unique earnings, leverage and risk tolerances.

The DAS framework uses a theoretical construct similar to that used to derive OAS. Calculating DAS involves estimating the cost of the default option, adding the cost of the default option to offered price of the subordinated MBS, calculating the new yield at the offered price plus the default option cost, and subtracting the yield from cost of capital to get the DAS.

A key part of the DAS framework is that it uses a simple approach to estimating the dollar cost of the default option. The cost of the default option is estimated as the difference between the subordinated MBS price calculated at zero losses and an "expected" subordinated MBS price. The "expected" price is calculated as a probability weighted average of the subordinated MBS prices calculated in various credit loss scenarios. Scenario prices are calculated using the cumulative loss rates that would wipe out the subordination and cause default for each of the AAA, AA, A, BBB, BB, B, and NR classes. The discrete probabilities used to weight the "expected" MBS price calculated in each credit loss scenario are derived from the cumulative density function using a mean credit loss rate and standard deviation. Chart 1 shows the probability functions derived at several different mean and variances for illustrative purposes. The "expected" MBS price is calculated by summing the products of scenario prices and probabilities.

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