Valuation Commentary

Think Twice Before Cutting Once…the Tail
By Alex Levin & Mickey Storms

Newly issued hybrid ARMS are frequently quoted in the secondary market using a Z-spread to Treasuries and a 15 percent "CPB". This method assumes a 15% CPR until the roll date and a balloon repayment of outstanding principal on the roll date. This pricing method fails to price the cap, floor and prepayment options inherent in hybrid ARMs and masks their true return and risk characteristics. The following analysis provides a better perspective on hybrid ARM relative value and risk using OAS analysis that captures the essence of hybrid ARM options. In this analysis, we focus on the value of the "tail" - the principal balance remaining of the ARM at the first reset date. It is well known that this value comes from an "excess margin" embedded in the ARM; we show, however, that the tail values can be considerably limited by reset caps.

Table 1 below details the indicative data related to the FN/FH hybrid ARMs analyzed.

Table 1: Indicative Hybrid ARM Data

ARM Type	Net Coupon	Current Roll	ARM Index	Net Margin	Cap Structure
3/1 YR	4.19	36	LIBOR 1YR	198	2/2/6
5/6 MO	4.17	56	LIBOR 6MO	161	5/1/6
5/1 YR	3.75	54	TSY 1Y	213	2/2/5
5/1 YR	4.75	59	LIBOR 1Y	175	5/2/5
5/1 YR	4.61	59	TSY 1Y	228	5/2/5
5/1 YR	4.71	46	TSY 1Y	200	2/2/5
5/1 YR	4.24	55	LIBOR 1Y	159	2/2/6
7/1 YR	4.34	82	TSY 1Y	229	5/2/5

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