Practical Applications from the Experts - March 2010

categories: Product Documentation, general

TBA Treatment

Mortgages are often traded in the TBA markets – they trade as a forward agreement where the seller agrees to deliver an MBS security with specific characteristics described in the TBA contract. We have introduced an approach to finding the cheapest-to-deliver security from a set of securities. Given a TBA CUSIP, the approach first identifies pools that have the same characteristics as the CUSIP. These pools are restricted to those that meet good delivery guidelines. The approach than determines the weighted average WAM, WAC, and WALA of the selected pools, where the weighting is based on outstanding balances.

These parameters are than used as inputs into our full pricing model for MBS which relies on 2 components - a simulation of interest rates and a prepayment model. The prepayment model is a statistical model from Andrew Davidson. This model uses Active Passive Decomposition to model burnout and assumes there are two subgroups within each pool—active and passive borrowers. Active borrowers are more likely to prepay in a low interest rate environment, while passive borrowers are relatively unresponsive to low interest rates. The model returns a forecast of prepayment speeds for each month that interest rates were forecast. Sources of prepayments include turnover, refinance, cash out and credit cure.

In the example below, 3 TBAs from the 3/2010 coupon stack with $10M notional each are shown (discount, slight premium, and high premium).

• Duration is highest for the discount bond as expected.
• Negative convexity arises due to the prepayment option which limits the upside potential in price when yields decline. Negative convexity is a characteristic of slight-premium MBS such as the FNMA 30Y 5% for which increasing prepayments place a drag on price increases as interest rates decline. Thus, for equal up/down changes in rates, the price is likely to decline more than it will increase.
• One can see how significantly duration changes for the slight premium TBA when interest rates are shifted by 25 BP.

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