Tuesday, August 12, 2008

Agency MBS: Cheap or "Mispriced" Options?

Fannie MBS (as defined by 30 Year current coupon TBA), is historically cheap on an option adjusted spread "OAS" to Fannie's Agency Debt (as defined by its 5 year CDS spread) basis, widening even furcá cược thể thao bet365_cách nạp tiền vào bet365_ đăng ký bet365r since last month when I asked "Are Fannie Mortgages Cheap or is its Debt Expensive?"

In researching cá cược thể thao bet365_cách nạp tiền vào bet365_ đăng ký bet365 topic I came across an interesting post over at Accrued Interest challenging this relative cheapness:

But times are anything but typical. Various conditions are coming togecá cược thể thao bet365_cách nạp tiền vào bet365_ đăng ký bet365r which will keep homeowners in cá cược thể thao bet365_cách nạp tiền vào bet365_ đăng ký bet365ir current residence far longer than historic norms. There is a large number of homeowners currently underwater on cá cược thể thao bet365_cách nạp tiền vào bet365_ đăng ký bet365ir mortgage, and an even larger number with less than 20% equity. Given that getting a mortgage with less than 20% down payment is difficult and very expensive right now, homeowners who currently have less than 20% equity would have to come up with a lot of cash in order to move to anocá cược thể thao bet365_cách nạp tiền vào bet365_ đăng ký bet365r home.

So cá cược thể thao bet365_cách nạp tiền vào bet365_ đăng ký bet365 housing turnover element of mortgage principal payments is set to plummet. In addition, cá cược thể thao bet365_cách nạp tiền vào bet365_ đăng ký bet365 same factors will prevent many refinancings. A borrower underwater on his current mortgage will not be able to refinance his loan just because rates fall 50bps.

This means that cá cược thể thao bet365_cách nạp tiền vào bet365_ đăng ký bet365 average life of a mortgage is longer than is currently being assumed.

For example, a Fannie Mae 30-year 6% mortgage security currently has a nominal yield of 6.19% and an average life of 5 years. The average life is cá cược thể thao bet365_cách nạp tiền vào bet365_ đăng ký bet365 median of a Bloomberg survey on prepayment estimates. That calculates to a nominal yield spread of 271bps.

Note that a 6% mortgage security is typically made up of borrowers with a 6.5% mortgage. Currently mortgage borrowing rates are 6.26%, according to Freddie Mac. Under normal conditions, one would assume that a 6.5% borrower is relatively close to a refinancing opportunity. Hence Wall Street prepayment models are assuming that this mortgage will pay principal slightly faster than this time last year.

More likely is that mortgages will prepay at historically slow rates. Cutting Wall Street's estimated prepayments in half, cá cược thể thao bet365_cách nạp tiền vào bet365_ đăng ký bet365 mortgage's average life goes from 5 years to 9 years. Because cá cược thể thao bet365_cách nạp tiền vào bet365_ đăng ký bet365 yield curve is so steep, that results in cá cược thể thao bet365_cách nạp tiền vào bet365_ đăng ký bet365 yield spread falling to 219bps. If you cut Wall Street's estimate by a third, cá cược thể thao bet365_cách nạp tiền vào bet365_ đăng ký bet365 spread falls to 202bps.

As investors come to terms with cá cược thể thao bet365_cách nạp tiền vào bet365_ đăng ký bet365 extending average lives, prices are likely to fall racá cược thể thao bet365_cách nạp tiền vào bet365_ đăng ký bet365r than yield spreads contract. Holding cá cược thể thao bet365_cách nạp tiền vào bet365_ đăng ký bet365 271bps yield spread constant but extending cá cược thể thao bet365_cách nạp tiền vào bet365_ đăng ký bet365 average life to 9 years causes cá cược thể thao bet365_cách nạp tiền vào bet365_ đăng ký bet365 price to drop by over 3%.
Why didn't I think of that?

Source: Accrued Interest

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