The Concept of Credit OAS in Valuation of MBS

Abstract

Neither the traditional option-adjusted spread (OAS) method nor a static loss forecasting is capable of providing a rational explanation of the pricing of traded asset-backed securities (ABS), credit default swaps, and loan protections. In this article, the authors introduce the concept of credit OAS, which revolves around the stochasticity of both interest rates and home prices. The credit OAS approach requires a risk-neutral stochastic model of home prices, a model of defaults and losses (theoretical or empirical), and a rigorous and efficient valuation scheme. The authors discuss how the risk-neutral conditions can be formed from concurrently observed prices of ABS tranches up and down the credit structure. An alternative is to analyze the cost of a GSE guarantee inclusive of capital requirements to support the guarantee. The authors illustrate their method with case studies in both liquid and illiquid markets. Even distressed market prices can be explained by a combination of modeled losses and a properly selected credit OAS level (i.e., liquidity spread). The greeks (risk measures), however, depend strongly on the modeling details (such as the link between interest rates and home prices), vary widely from model to model, and tend to be far away from traditional measures.

TOPICS: MBS and residential mortgage loans, asset-backed securities (ABS), statistical methods