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Evaluating Leveraged Returns and Pricing Dynamics in MDX Swaps
MDX Swaps are intended to be a derivative complement to mortgage credit products and portfolio management. By comparing the levered return profiles of mortgage bonds and loans to MDX Swaps, investors can more accurately evaluate MDX pricing in advance of launch. To undertake this analysis, representative levered mortgage credit return profiles including MDX Swaps estimates are provided below.
Mortgage securities, loans and MDX swaps have certain fundamental borrower and structural differences that affect the measurement of their levered return profiles. Adjusting for these differences is required to compare pricing and expected returns. Vista has created a flexible model that incorporates key pricing and return variables for a range of security types and loan packages. Click here to download the model.
Margin and funding differences among mortgage credit products and MDX swaps need to be included within comparative return profiles. Increased credit exposure and greater structuring generally reduce leverage availability and consequently affect the pricing of various loan types and securities. Most cash mortgage credit products today have margin (haircut) requirements ranging from 5% to 20%, and MDX Swaps are expected to be at the bottom of that range. Funding cost differences between securities, loans and MDX Swaps also impact return profiles and pricing. While funding costs vary among cash securities and loans, they mostly fall in a range of SOFR plus 84 bps – 125 bps. MDX swaps do not have funding requirements – so pricing and returns do not need to account for funding costs. Since margin and funding metrics are well known, relative pricing among mortgage credit products already adjusts for these differences, leaving further pricing consideration to be driven by credit and other factors.
Structured and non-structured differences need to be addressed when comparing most mortgage securities to MDX. The return profiles for non-QM and CRT securities are affected by uneven cashflows based on how their payment waterfalls distribute credit support and losses. Changes in prepayment rates often have an exaggerated impact on the pricing and return profiles of structured securities, particularly as compared to unstructured whole loans and MDX Swaps. This makes direct credit return comparisons difficult without taking structuring into account. To accommodate this difference, traders typically adjust net return profiles by loss expectation differences to arrive at “loss-adjusted returns.”
Cash mortgage credit products usually incorporate loss expectations directly into pricing and return assumptions such that trading levels reflect a combined view of prepayments, risk premiums and credit losses. Credit losses play a relatively minor role under current market conditions; most securitized mortgage credit products transact based on a zero-loss assumption, and whole loans price in fairly small losses. MDX swap performance, meanwhile, is driven substantially by credit and is only indirectly impacted by prepayments. In the table above, the MDX Swap return profile removes the additional spread related to expected Credit Event losses.
MDX Swap pricing will ultimately determine the instrument’s attractiveness as a levered investment mortgage credit product. In general, derivatives represent alternatives to cash investments when undervalued based on their expected return profile. When they are overvalued, they gain utility as hedges or outright short positions. Mortgage credit products have lacked a consistent benchmark to measure relative value. As MDX swaps develop, they can begin to play that role.