Updating the MSCI Agency MBS model for the COVID-19 crisis

• The coronavirus pandemic has put tremendous strain on the U.S. mortgage market, disrupting both primary mortgage originations and the secondary securitization market.
• Near-term prepayment speeds have been profoundly distorted — challenged by opposite effects from historically low interest rates and widespread public lockdowns and attendant economic disruption.
• We updated the MSCI Agency MBS Model to adjust for the near-term shocks and help clients manage this unprecedented risk.

The COVID-19 pandemic has put tremendous strain on the U.S. mortgage market, as near-term prepayment speeds have been profoundly distorted by the current distress. With the market for mortgage-backed securities (MBS) in uncharted territory, we updated the MSCI Agency MBS Model¹ to adjust for near-term shocks and assist clients in the current crisis.

Tremendous strain on the US mortgage market

One key barometer for the mortgage market is the agency-MBS current-coupon spread — i.e., the spread between the to-be-announced (TBA) market’s implied MBS current coupon yield² and the Treasury/swap curve. Instead of the nominal spread — the simple difference between MBS current coupon yield and the 10-year U.S. Treasury yield — or prepayment-model-assumption-dependent option-adjusted spread (OAS), we can obtain a dynamic current-coupon spread by running MSCI’s proprietary current-coupon model.³

Current-coupon spread spiked despite low credit risk of MBS relative to other areas of fixed income

Current-coupon spread is calculated using the MSCI Current Coupon Models and swap curves.

At the height of the 2008 financial crisis, the current-coupon spread for agency MBS shot above 120 basis points (bps). This was despite the low credit risk of agency MBS (relative to other areas of fixed income), which are implicitly backed by the U.S. government. Decisive action by the Federal Reserve at the time calmed the MBS market, with spreads falling back below 50 bps within a few months. In the years since, the spread has mostly remained within a range of 10 and 40 bps — until the coronavirus pandemic began to affect all aspects of our life and unnerve global markets. The exhibit above shows the recent spike in the spread, which demonstrated extreme distress in the MBS market. Although the Fed’s March 15 announcement of a zero-rate policy and new round of quantitative easing tightened the spread by 30 bps, it subsequently widened even further within the same week, amid the broad sell-off of MBS and other products that trade at a spread to Treasurys.

A record high for the primary/secondary spread

The primary/secondary spread⁴ — or the spread between the mortgage rate at which homeowners can borrow and the current coupon yield — is a key indicator for gauging the strain in the mortgage-origination business. This spread reached 140 bps recently, a historical high, as shown in the exhibit below. The short-term dynamics of the primary/secondary spread is dominated by lender-origination capacity. Lower mortgage rates have historically led to surges in refinance applications, but the coronavirus pandemic might have significantly curtailed lenders’ capacity. Lenders usually offer a two-month, nominally free mortgage-rate lock, thanks to the U.S. MBS market’s forward settlement practice. Operational uncertainties might have increased lenders’ wariness and led to more conservative pricing, exacerbated by the current extreme intraday rates volatility.

Primary/secondary spread has reached a historical high

The primary/secondary spread is calculated using Freddie Mac Primary Mortgage Market Survey 30-year rates and the Fannie Mae 30-year current coupon yield.

Near-term prepayment speeds may be contained

MBS valuations are usually based on assumptions for long-term future cash flows. Meanwhile, the economic disruptions caused by the COVID-19 pandemic will continue for an undetermined period of time. Projecting the current market strain to last indefinitely or ignoring the near-term prepayment shock could both lead to erroneous model assumptions. We used our updated MBS prepayment model, which considers both short- and long-term effects, to assess the potential impact on each component of overall prepayment levels.

Forward mortgage-rate projection depends on swap/Treasury curves, volatility surface and assumptions for forward spreads. Spread distortions have usually reverted to historical-level means in the past, eventually reaching equilibrium, as elevated volatility during price discovery has abated. As with the previous version, our updated MBS prepayment model assumes the spikes of primary/secondary spread and current-coupon spread will revert to recent multiyear averages. Assuming perpetual spread widening could introduce false volatility into the valuation and risk measures.

Prepayment speed consists of several components: housing turnover, refinance, cash-out, buyout and curtailment.

• Housing turnover usually leads to early termination of the mortgage contract, because the house is sold. Open houses are being canceled across the country.⁵ Home sales could slow dramatically in the next few months, especially in areas with higher infection rates.  
• Refinancing involves a large amount of paperwork to help homeowners achieve their goal of lower monthly payments. Although some technology-driven lenders and providers have digitized this process to a certain extent, some procedures still require manual in-office operations and even the physical presence of the borrowers and lender representatives (e.g., appraisers and closing agents). Various entities are currently working on the tactical solutions to alleviate the operational barriers.⁶ 
• Cash-out refinancing — in which the borrower replaces an existing mortgage with a mortgage with a larger balance and keeps the difference in cash — may be de-prioritized in the near term, as stricter paperwork is required to take out home equity. Cash-out activity nearly came to a halt during the previous global financial crisis (GFC).  
• Technically, buyout occurs when agencies (or servicers, in the case of Ginnie Mae MBS) remove the loan from the MBS pool after a period of delinquency status. The payment-forbearance plan, which does not automatically trigger the buyout, is supposed to be a temporary relief for borrowers. Homeowners’ financial hardship may not be totally relieved by the government rescue plan, which could lead to a higher mortgage-default rate months later.  

As the previous version of the MSCI Agency MBS Model was calibrated to the experience of the GFC and its aftermath, the updated model takes into account the coronavirus pandemic’s potential impact on the economy, U.S. housing market and agency-MBS performance.

Summary of changes in the updated MSCI Agency MBS Model

¹Yu, Y. 2018. “MSCI Agency Fixed Rate Base Prepayment Model.” MSCI Model Insight.
Yu., Y. 2018. “MSCI Agency Fixed Rate Refinance Prepayment Model.” MSCI Model Insight.

²Zhang, D., Yu, Y., Voros, M., and Biro, I. 2020. “Agency MBS Current Coupon Calculation from TBA Prices.” MSCI Model Insight.

³Yu, Y. and Zhang, D. 2019. “MSCI Current Coupon Models: Model Risk Premium in a Risk-Neutral Model.” MSCI Model Insight.

⁴Yu, Y. 2018. “MSCI Primary-Secondary Mortgage Spread Model.” MSCI Model Insight.

⁵Lansner, J. “Coronavirus cutback: California Realtors told to stop home showings, open houses.” Orange County Register, March 20, 2020.

⁶Mollot, S. “Cuomo allowing virtual notarizations during crisis.” Real Estate Weekly, March 22, 2020.
“FHFA Directs Enterprises to Grant Flexibilities for Appraisal and Employment Verifications.” Federal Housing Finance Agency, March 23, 2020.

Further Reading

Navigating market volatility with agency MBS models

Coronavirus and a potential MBS convexity whipsaw

Is MBS refinance risk increasing?