The Post-Crisis World: Where Will Agency MBSs Trade?

Transcription

1 The Post-Crisis World: Where Will Agency MBSs Trade? Financial Engineering Practitioners Seminar DEPT. OF INDUSTRIAL ENGINEERING AND OPERATIONS RESEARCH SCHOOL OF ENGINEERING AND APPLIED SCIENCE COLUMBIA UNIVERSITY November 3, 2008 LEON TATEVOSSIAN Associate, IEOR Department, Columbia University cell:

2 OVERVIEW Quick summary of the mortgage market. What is the mortgage basis? Conventional wisdom on the mortgage basis. What s different today? Or maybe we should ask: What s not different today? What will the long-term steady-state look like?

3 BUILDING BLOCKS Fundamental concept: pool of mortgage loans. Securitized into an agency pass-through or a private-label pass-through. Fixed-rate agency pass-throughs: -- Guarantee fee ( G-fee ) is paid to the GSE to insure the loans. -- Servicing (to receive/remit payments and pay associated charges). -- Usually securitized in 50 basis-point increments.

4 WHERE ARE MORTGAGE RATES TODAY? from Mr. Paulson s September Surprise: Perspectives on the Mortgage Basis, MBS Market Discussion (by Paul Jacob), Sep. 10, 2008

5 LONGER-TERM PERSPECTIVE OF MBS SPREAD from Mortgage Valuation and the Agency MBS Basis During the Financial System Restructuring, MBS Market Discussion (by Paul Jacob), Oct. 14, 2008

6 WHAT DETERMINES THE MORTGAGE RATE? Old model (pre-early 1980 s): -- Borrower s credit worthiness. -- Lender s cost of funding and return-on-equity target. -- Qualitative recognition of prepayment risk. Capital-markets model (early 1980 s to early 2000 s): -- More active management of originator portfolios. -- GSE s balance-sheet capacity and program innovation. -- Systematization of the hedging problem. Dominance of the securitization model (post-early 2000 s): -- Emergence of non-depository originators. -- Enlargement of non-bank investor base. -- Stratification of credit and prepayment risk. -- Drilling down to weaker-credit borrowers (!).

7 WHY DID THE SECURITIZATION MODEL BREAK DOWN? Multiple contributors to a systematic collapse of underwriting standards. Key drivers included: -- Explosion of stated-income-based lending. -- Acceptance of very low down payments (LTVs and CLTVs >= 95%). -- Lenders failure (and investors inability) to distinguish homeownership- vs. speculation-driven borrowing. -- Aggressive innovation of affordability products (interest-only loans, hybrid ARMs, pay-option loans) for weaker-credit borrowers. -- Nominal spreads on over-innovated collateral (with minimal performance history) had to be adjusted upwards to overcome investor resistance.

8 INADEQUACY OF REGULATORY OVERSIGHT Growing portion of origination came from non-regulated entities (beyond Federal Reserve, OCC, and OTS oversight). Joint guidance (on non-standard mortgages) was released in mid one year after the beginning of the pull-back in housing prices. Some evidence that migration to Basel II delivered a competitive advantage to IBs. Banks were forced into an over-reliance on unstable off-balance-sheet funding strategies (SIVs).

9 FANNIE MAE AND FREDDIE MAC Balance-sheet growth and margin-preservation objectives fueled a move down in credit quality. Reduced confidence in prepayment-risk management (among internal risk departments and Wall Street analysts). Need for continued earnings growth in the context of tighter spreads and the de-emphasis on convexity management led to an explicit enlargement of portfolio capacity for lower-tier borrowers.

10 BEFORE WE TALK ABOUT THE FUTURE BACK TO REGIME # 2: OPTION THEORY MAKES ITS MARK Borrower s right to prepay introduces negative convexity in the price performance of a mortgage asset. Practitioners realized that the key linkage is the prepayment model. Concepts familiar to the options domain began to co-exist with empirical analysis of mortgage-price movements.

11 CALLABLE AGENCY BOND: OAS CALCULATION

12 AGENCY PASS-THROUGH: OAS TO TSY CURVE

13 AGENCY PASS-THROUGH: OAS TO SWAP 39.55% VOL

14 AGENCY PASS-THROUGH: OAS TO SWAP 25% VOL

15 2-YR AGYS: SPREAD TO TSYS

16 2-YR AGYS: SPREAD TO SWAPS

17 RATE CURVES: OCT 6, Tsy Agy Swap

18 AGY PASS-THROUGHS: NOMINAL SPD TO TSYS

19 AGY PASS-THROUGHS: NOMINAL SPD TO TSYS (LONG-TERM VIEW) from Mr. Paulson s September Surprise: Perspectives on the Mortgage Basis, MBS Market Discussion (by Paul Jacob), Sep 10, 2008

20 AGY PASS-THROUGHS: NOMINAL SPD TO SWAPS

21 AGY PASS-THROUGHS: NOMINAL SPD TO SWAPS (LONG-TERM VIEW) from Mr. Paulson s September Surprise: Perspectives on the Mortgage Basis, MBS Market Discussion (by Paul Jacob), Sep 10, 2008

22 NOMINAL SPD TO SWAPS: AS FUNCTION OF RATES AND VOL from Mr. Paulson s September Surprise: Perspectives on the Mortgage Basis, MBS Market Discussion (by Paul Jacob), Sep 10, 2008

23 LOGNORMAL VOL: 5-YR x 5-YR SWAPTION

24 LOGNORMAL VOL: 6-MTH x 2-YR SWAPTION

25 GAMMA RENT: 6-MTH x 2-YR SWAPTION

26 SNAPSHOT: PRIMARY MARKET (Barron s, Oct. 6, 2008)

27 TSYS/AGYS/SWAPS: CURRENT MARKET LEVELS

28 FED FUNDS EFFECTIVE RATE

29 FED FUNDS EFFECTIVE RATE (SINCE JULY 2008)

30 3-MONTH LIBOR

31 2-YR SWAP SPREAD

32 LIBOR/OIS SPREAD

33 GENERIC 3-MTH T-BILL: OCTOBER 7 (INTRA-DAY)

34 NEW REGIME: FEDERAL HOUSING BANK Government-owned successor to Fannie Mae and Freddie Mac: -- Guaranteed by US Government. Stabilize the basic Fannie and Freddie pass-through programs. System will ultimately settle on the new balance-sheet allocation of mortgage risk: -- FHB. -- Depository institutions (interest-margin driven). -- Competitive return buyers (asset managers). -- Foreign ownership (e.g. CBs, SWFs). Key question for the equilibrium price level is the steady-state amount of credit risk retained by the FHB.

35 FOLLOW-UP DISCUSSIONS Leveraged Losses: Lessons from the Mortgage Market Meltdown by David Greenlaw, Jan Hatzius, Anil K Kashyap, and Hyun Song Shin. (U.S. Monetary Policy Forum Report No. 2, Rosenberg Institute, Brandeis International Business School and Initiative on Global Markets, University of Chicago Graduate School of Business, 2008.) Mortgage Valuation and the Agency MBS Basis During the Financial System Restructuring by Paul Jacob. (MBS Market Discussion, Oct. 14, 2008) In My View: Making TARP Work by Bill Berliner. (Asset Securitization Report, Oct. 27, 2008).