The Emperor's New Clothes

OAS Analysis is not a Valuation Tool
August 11, 2010, 12:44 pm
Filed under: Valuation Tools | Tags: , , , , , , ,

Option-adjusted spread (“OAS”) analysis is not well understood by our industry.  OAS should not be used to generate an assessment of value but, rather, as a very useful output of the valuation process.  It is an important financial tool that adds tremendous insight into the risk dynamics of mortgage related assets, but it does not produce a market or economic value.

The process of developing an OAS is very telling:

  • Generate a large number of randomly generated future interest rate paths;
  • Produce cash flows along each path at a risk-free rate plus a spread;
  • Obtain a simple average of the net present value of these cash flows;

This produces a simulated price.

  • If this simulated price does not equal the market price, choose another spread and rerun;
  • Repeat this process until the simulated price equals the market price

The resultant spread is the OAS.  This OAS is calibrated to market value; not the other way around.

The current usage of OAS analysis as a tool to determine price implies that we know the risk spread that the market demands and, thus, can use this spread to determine price.  This is intellectual hubris.  The spread is predicated on a large number of very complex assumptions and models, few of which are directly observable in the marketplace.  These assumptions include, but are not limited to:

  • Rate volatility (the speed at which future short rates change from their current implied values
  • Rate constraints (high/low)
  • Mean reversion properties
  • Distribution (normal or log normal)
  • Yield curve model (instantaneous forward rate or short rate)
  • Interest rate path generation (single or multi-factor)

Additionally the OAS, while ostensibly a stochastic measure, is heavily influenced by a deterministic prepay model.  While most analysts would test their OAS with sensitivities based on 90% or 110% of these prepay models, this simply “measures the sensitivity of OAS to consistent misestimation of the prepayments … not to random fluctuations around the model’s predictions.”[1]

And, even if these assumptions were observable and defensible, the option adjusted value is still meaningless from a valuation perspective.  It is an average of hundreds of different interest rate paths.  Possibly one of them is the correct path (i.e. what actually occurs), but there is no assurance that this is true, nor is there even a meaningful probability that this path is the “average” path that the OAS concludes.  “It is extremely unlikely that a security will actually earn its calculated OAS.”[2]

If you look at the distribution of values that an OAS analysis produces, you will see my point.  A greatly simplified example is shown below. 

This simplified example shows only five possible outcomes: a yield on the investments of: 0%, 7.5, 15, 22.5 or 30%.  The model generates a frequency distribution of these returns as indicated from a low of 3% to a high of 40% (naturally they sum to 100%).  As is typical with mortgage related investments, the distribution is not normal; it is negatively convex (skewed to the left).  Because an OAS value is a simple average of values over the entire distribution, the OAS value in this case would result in an average return of 15% (the “mean”).  Not only is this value far from a certain outcome, but it is not even the most probable outcome.  The most probable outcome (the “mode”) returns only 7.5%.

I would not pay a price that equates to a yield of 15% when the most probable outcome is a yield of 7.5%.  Additionally, I would look closely at the dispersion of the expected returns emanating from these hundreds of paths.  If the deviation around the mode is small, I may be willing to pay the price related to the modal price (never the mean price).  If the dispersion, however, is large, I would discount the price substantially.

OAS provides very useful information about the expected cost arising from the mortgagors’ ability to prepay at will.  It does not, however, measure credit risk nor does it provide the answer to the question of “what is the value of this asset”?

OAS has become a fad; one number that ostensibly summarizes the entire range of financial dynamic of the mortgage asset.  Yet this is not what the architects of OAS intended.  They never “intended the OAS to be viewed as a ‘yield takeout’ over Treasuries.  Because it’s the result of an averaging process.”[3] Financial analysts love to talk about OAS while disparaging scenario and other analyses.    Yet, from a market value perspective, OAS is a very elegant and expensive way of being wrong.


N.B.  Blogs do not allow for a lengthy discussion of any subject.  I will be publishing a more comprehensive discussion of this topic in Mortgage Banking Magazine and will advise those who are interested as to its publication date.

My next blog will address level 1 (under FAS 157) alternatives to valuing mortgage related assets.  This will not be available until the first week of September.  For the remainder of this month I will be focused on producing an article for Mortgage Banking Magazine (October 2010 edition) on identifying paradigm shifts in our industry before they wreak their havoc on us.

[1] Robert W. Kopprasch, Financial Analysis Journal, May-June 1994; page 45

[2] Robert W. Kopprasch, Financial Analysis Journal, May-June 1994; page 43

[3] Robert W. Kopprasch, Financial Analysis Journal, May-June 1994; page 43

The Impact of Credit on Residential Mortgage Pricing
August 3, 2010, 1:17 pm
Filed under: Credit | Tags: , , , ,

Everyone knows there is a relationship between the cost of a mortgage loan and the borrower’s credit strength.  The precise relationship, however, is less clear.  Lenders expend a great deal of resources to determine the true cost of defaults so that their pricing is accurate on a risk adjusted basis.  Level 1 Loans has examined seventeen of the largest lenders’ rate sheets to quantify the effect that credit scores and loan-to-values have on their pricing; all other product characteristics were held constant.  We examined the pricing of a hypothetical loan with the following characteristics:

  • $300,000 principal balance; 1st lien;
  • 4.50% fixed rate coupon; 30 year term;
  • Collateralized by property located in Ohio;
  • Full documentation; conventional

We looked at pricing from our database of the major aggregators’ product offerings, underwriting guidelines, stipulations and rate sheets.  This data is updated daily.   The results (below) show a spread of 310 basis points between the highest price offered for this hypothetical loan (102.17 @ 60% LTV & 780 FICO) and the lowest (99.07 @ 95% LTV & 620 FICO).  As can be seen, this is not a linear function.  In fact, pricing is almost flat for FICOs >= 720 with LTVs >= 65%.  Below this 720 threshold, however, the expectation of losses climbs and prices plummet.

Loss expectations are driven by the probability of default (PD%) and the severity of a projected loss, i.e. the loss given default (LGD%).  While mortgage lending is a behavioral science, and many demographic factors relate to mortgagor defaults, we have limited this review to loan-to-value and credit scores.  The PD% is primarily driven by credit score, while the LGD% is more a function of LTV; although the two are inextricably intertwined.  Credit scores have minimal impact on pricing at the lower LTVs (62 bp swing @ 60% LTV) while they influence pricing by 285 bps at 95% LTV.  Likewise, LTV variations have de minimus impact on pricing (26 bps) at credit scores over 720 but a 248 bp swing in pricing for the lower credit score mortgagors.

On a $300,000 loan, a swing in pricing of 310 basis points implies expected losses of approximately $9,300.  This expected cost is passed onto the mortgagor in terms of either upfront points and/or a higher coupon.


For  additional information please feel free to access our daily database of loan pricing indices (LPI) at

Mortgage Markets – week ending 6/4/10
June 4, 2010, 6:10 pm
Filed under: Mortgage Markets | Tags: , , ,

The 10 year Treasury rate inched back up another 8bps to 3.39%; although the 30year mortgage rate did not follow, remaining essentially flat. The bigger news, however, is that that 10.5% of those that already have bank-owned mortgages (approximately $2.5T) have decided not to make their payments.  As the graph below shows, March 31, 2010 call report data shows that delinquencies continued their inexorable climb.

Mortgage Rates – week ending 5/28/10
June 1, 2010, 5:40 pm
Filed under: Mortgage Rates | Tags: ,

The 10 year Treasury rate inched back up to 3.31% from 3.25% a week ago.  Correspondent mortgage rates rose as well; although by 14 basis points.  Retail rates lagged in their response to this uptick in the market and dropped slightly (6bps) to 4.78%.  The resultant spread between the primary and correspondent rates is down to 18 bps; unsustainably low.  I would expect this spread to get back to a more normal 25-30 basis points next week.

Mortgage Rates – week ending 5/21/2010
May 23, 2010, 5:27 pm
Filed under: Mortgage Rates | Tags: , , ,

Very interesting week!  The stock market plummeted bringing the 10 year Treasury rate down with it.  The 10 year ended the week at 3.25%, down 31bps from a week earlier.  As might be expected, mortgage rates dropped as well.  Correspondent mortgage rates came down 21bps to 4.46% while retail rates dropped only 9bps to 4.84.  It is not unusual to see this kind of lag between the index rate (treasury), the secondary rate and the primary rate.  I would expect some catch up next week.

Mortgage Rates – week ending 5/7/2010

Correspondent par mortgage rates dropped 9 basis points over the last week ending at 4.67%; the spread over the 10 yr treasury increased from 100bp to 126bps.  The spread to the Freddie Mac primary market survey rate of 5.00% increased from 30 to 33 basis points.

The  jumbo market seemed to have lost some of the euphoria from Redwood Trust’s successful private-label jumbo securitization.  Spreads to comparable conforming product increased from 174 to 207 basis points; a still relatively attractive spread.

NB.  For daily pricing on a more diverse set of loan programs please visit Level 1 Loans Index or visit us at Booth 109 during the New York Secondary conference.

Dec 2009 FHFA Housing Prices – Is the recession over?
April 30, 2010, 3:21 pm
Filed under: Housing Prices | Tags: , , , , , , , , ,

The assertion that the recession is over reminds me of Bill Clinton’s defense of his assignations with Monica Lewinsky … he simply defined the word “sex” rather narrowly.  Likewise, the economists’ definition of “recession” is fairly narrow.  It is “two down quarters of GDP”.  By that definition, the recession is over.  However, for the 9.7% of our workforce that are unemployed, and the 49% of homeowners with mortgages that are underwater, it sure doesn’t feel like it has ended.

We might reasonably expect that our high unemployement rates and housing markets will return to their respective norms.  I believe this to be true.  The major caveat, however, is that real estate prices have already done this. We are at the norm!  The 2005/2006 real estate prices were an aberration that we will not see again.  We have not experienced a temporary declination in values, but rather a permanent correction.

As is well known, real estate prices have fallen off the cliff in many markets.  From peak-to-trough the Miami CBSA has fallen 44%; Oakland 41%; and Phoenix 42% (to mention just a few).  Interestingly, however, other markets such as Dallas have shown modest but consistent growth in real estate values over the past twenty years.  In fact Dallas is currently at its twenty year peak.  The difference between the bubble and the non-bubble markets lies in one very important statistic; namely, real estate value as a multiple of per capita income.

It goes without saying that there is a relationship between home prices and mortgagors’ income.  For example, if you buy a $300,000 home with 10% down, your principal and interest payments would approximate $1,500/month.   Throw in another $250 for taxes & insurance and you have a housing cost of $1,750/month.  At a 28% housing ratio, this translates to an income requirement of $75,000 per year.  Thus, in this example, the mortgagor could afford a house equal in value to 4 times annual income.

Actual value/income went through the roof in the bubble years.  CBSAs such as Oakland had value/income ratios in excess of 9, while Dallas was only 4 .  While a nine multiple may be supported short term by home owners trading amongst themselves, it precludes buyers from moving from a low ratio area into a high ratio one.  In the long term it is unsustainable.  Real estate prices have essentially declined to sustainable levels over the last couple of years.

Accordingly, government attempts to support real estate values are akin to Sisyphus continuously trying to roll a rock uphill.  The best we can do is to mimic Captain Sullenberger in his crash landing of Flight 1549 in the Hudson River.  We may be able to control the descent, but there is no way in the world we can artificially inflate the real estate markets above their sustainable levels.

So, is the recession over?  It depends on how you define “recession”.

NB … data used in this blog were obtained from www.PredictiveData.Info.  The author is the owner of this data research firm.