MBS Remain Somewhat Insulated From Rates Market Volatility


After a few relatively quiet weeks, interest rate volatility exploded
again last week, triggered by European turmoil and the MF Global
bankruptcy.  Using a relatively short (45 day) lookback period, realized volatility (i.e., the standard deviation of daily rate changes) for the 10-year Treasury increased sharply over the past 1 1/2; weeks, from 7.4 basis points to 8.4 bps. 
Without getting too technical, this reflects the sharp run-up and subsequent
retracement in yields.  For example, the
10-year yield bottomed out at just over 1.75% on 10/3; it reached as high as
2.40% on October 27th and is now hovering around 2%.

The spike in volatility was triggered by the announcement of
an interim settlement to the European debt crisis, which subsequently crumbled
when the Greek PM announced that it would be put to a vote with the Greek
electorate.  As with previous agreements,
this “settlement” had the aroma of a highly clever solution that was unlikely to
make a long-term difference; it’s hard to understand the notion of a
“voluntary” writedown of half the value of a group of assets without it
constituting a “default.”  Until the vote
is actually taken, more market volatility (as comments and statements by the
players are parsed) is likely.

What’s interesting is that the spike in realized volatility
has not yet drifted over into either the options markets or the MBS
sector.  “Implied” volatility (which is
essentially a “plug” that allows for options to be quoted on an
apples-to-apples basis) has not drifted higher despite the see-sawing in market
yields.  In theory, implied and realized
volatility should move together; however, in practice the two measures often
decouple.  This has arguably given some
support to MBS valuations, since OAS models use implied vols as an input.  The 30-year current coupon spread tightened
about 8 basis points versus interpolated Treasuries last week, although it has
widened a few basis points this week.

An interesting discussion swirling around the MBS community
relates to the likelihood of a sharp pickup in prepayment speeds from the HARP II
initiative.  The latest discussions
center on the waiver of rep warranty claims on loans that are refinanced
under the program.  The discussion goes
as follows:  can large servicers limit
their exposure to buyback claims from the GSEs by simply refinancing all
eligible loans?  It seems like a fairly
tempting option.  My view, however, is
that originators are already having operational problems processing the current
level of applications; I’m also skeptical that lenders can ystematically
contact large numbers of eligible borrowers. 
Particularly with the turmoil surrounding BofA’s withdrawal from the Correspondent
Lending market, I don’t think it heralds a significant spike in activity, even
if refinancing large numbers of these borrowers would make economic (and legal)

The Fed concluded the two-day meeting of the
Open Market Committee with no change to monetary policy.  However, they did leave the door open to more
actions by the Fed to stimulate growth, and indicated that the purchase of more
MBS was a viable option in the future. 
My gut is that another round of purchases would have little impact on
housing, except if they were to
commit to buying sizeable amounts of 30-year 3.0s.  The fact that there is virtually no liquid
market for 3% coupon passthroughs effectively puts a floor under primary
mortgage rates; unless the base servicing requirement of 25 basis points is
relaxed, there is currently no reliable outlet for loans with rates below

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