The S-Curve

On the Road Away from LIBOR

Alex Levin

The release of Andrew Davidson & Co., Inc.’s (AD&Co) new generation of financial engineering tools marks a shift to a new reality; when the traditional benchmark for MBS valuation, the LIBOR/ Swap yield curve, becomes unavailable. Our recent Product Release email informed our readers about the change. In short, our users can:

  • Conduct valuation relative to one of three benchmark rate curves: Treasury, LIBOR or SOFR.
  • Provide either an absolute rate volatility matrix or the traditional relative volatility matrix.
  • Apply a negative shift (floor) to otherwise positive-rate models (Squared Gaussian or Black-Karasinski).

The 3-benchmark valuation option provides analytical flexibility within the transitional period of LIBOR availability and well beyond; hence, this is both a "transitional" and "permanent" solution. Regardless of the benchmark chosen, SOFR-indexed ARMs and CMO/CRT floaters will use a SOFR term structure of rates (if provided) for the index projection. If a SOFR term structure isn’t provided, we will project SOFR indices off the chosen benchmark plus the initial spread.

The absolute volatility quotation has grown as a popular format. It represents the best practical choice when a valuation benchmark (e.g. Treasury) is different from a volatility source (e.g. options of SOFR swaps).

Which yield-curve benchmark should practitioners use for valuation? About 30-40 years ago, MBS were priced off Treasury bonds, a close investment alternative. However, Treasury rates have never been borrowing rates; this honor belonged to the LIBOR market. A pricing spread to a borrowing curve can be easily translated into return on equity (given the leverage) and, unsurprisingly, the LIBOR/Swap curve became the dominant benchmark.

With the upcoming demise of LIBOR, the current market trend suggests a return to Treasuries. Most dealers now report exclusively Treasury OAS on TBAs. The Security Finance Association (SFA) established a task force that recommended one of the Treasury-based spreads. The so-called I-curve (interpolated-WAL curve) was voted the best quotation option according to the SFA by “a supermajority of investors, traders and syndicate desks…across all structured finance products” whereas “issuers and bankers are split on the benchmark they favor with a slight majority preferring a Treasury-based curve over the SOFR swap curve.” To reiterate, our tools are ready for a change in prevailing practice.

What about the preferred source of volatility? With the Treasury curve returning to the benchmark role, which market volatility would we recommend of using? The only Treasury-related options – options on Treasury futures – represent a thin layer of information, which, at best can be interpreted as volatility on long bonds. While they may help decipher the value of the embedded prepayment option, they are less relevant to caps and floors found in CMO/CRT floaters and ARMs. It is also impossible to calibrate the mean reversion parameter of a term structure model without observing volatility quotes on differing tenors.

Our recommendation, which may be unexpected at a first glance, is to consider options on SOFR-based swaps that have developed in a way similar to LIBOR-based swaps. Since Treasury rates differ from SOFR-swap rates, we recommend using absolute (aka “normal”), rather than traditional relative (aka “lognormal” or Black), volatility inputs. Essentially, we posit that, given a tenor, various US rate benchmarks tend to exhibit similar volatilities. Our review of the SOFR/Swap volatility and LIBOR/Swap volatility confirms this assumption – despite the difference in rate’s levels.

Are we changing the Current-Coupon Yield (CCY) model? The existing CCY model is a linear regression calibrated to a multi-year historical movements against the 2-year and the 10-year points of either Treasury or swap rates. The SOFR term rates are relatively short in history and at the point of writing, there is no immediate reason to change the model’s coefficients when the SOFR curve is chosen as a benchmark. Going forward, this statement merits a review; the entire approach to projecting CCY from benchmark rates may also need to be reassessed.

Are we changing the LoanDynamics Model (LDM) at all? Borrower behavior for SOFR-indexed ARMs is likely to be unaffected by the index’s name, as long as we control for the current and projected loan rate. At this time, we have no history of SOFR-ARM prepayments or defaults that warrants any revisions of LDM.