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Pricing at Market Extremes and Day-to-Day
We are frequently asked how MDX.GN swaps would likely perform under various market conditions. To answer that question, we point to three specific time periods that cover extreme macro stress (COVID), idiosyncratic mortgage stress (rapidly rising interest rates), and normal transactional flows to illustrate likely outcomes. Establishing approximate MDX swap pricing under these three scenarios provides a framework for understanding likely MDX.GN swap pricing both day-to-day and under stress market conditions. While there are several methods to price the spread components of MDX.GN swaps — namely, Credit Event (CE) spread and risk premium spread — we use CRT pricing to estimate implied CE spreads and CDX IG to generate loss-adjusted risk premiums. Both sources offer transparent daily historical values, though we expect MDX.GN trading levels will calibrate to market loss and return expectations for each Series. We look forward to your feedback on this and other related pricing analysis as we approach the start of MDX.GN trading.
Market Conditions During Early COVID provide a recent test of pricing MDX swaps during an extreme macro stress period. Both CDX and CRT reached their high spreads/low dollar prices between March 15 and April 15, 2020. Meanwhile, the 30 days between June 15 and July 15, 2022, offered an environment for idiosyncratic mortgage stress, as interest rates began to increase rapidly.1 MDX swap pricing can be estimated for these periods using CDX IG and CRT spreads as benchmarks. To accomplish this process, loss-adjusted risk premiums are derived from CDX IG and combined with CRT spreads adjusted for differences in structure, collateral, and funding. All spreads are annual.
The first step is to compute the equivalent CE spread for MDX.GN swaps by adjusting CRT spreads for differences in structural leverage, severity, and collateral. Structural and severity differences are based on CRT tranche and MDX.GN swap specifications, while CE rate differentials between conforming and Ginnie Mae collateral have averaged about 100 bps over the past 5 years.
Gross MDX.GN spreads are then calculated by adding a loss-adjusted risk premium to the implied CE rates. The widest CDX IG spreads during the COVID and 2022 sample periods were 145 bps and 102 bps respectively. These levels are used to estimate the peak loss-adjusted risk premiums during these periods.
Finally, gross MDX.GN swap spreads derived from CRT pricing are adjusted downward to reflect financing costs for cash CRT tranches compared to MDX.GN swaps, which have no funding requirements. This difference is known as a “negative basis,” where cash securities trade at wider spreads than matching or equivalent derivative products. The estimated negative basis between CRT pricing compared to MDX.GN swaps during COVID is based on typical financing rates for CRT M2 and B1 tranches.2 During the idiosyncratic stress period of mid-2022 and otherwise quiet periods, the negative basis may be less than financing costs.
The Composite View of CDX, CRT, and MDX during these two stress periods is as follows:
Day-to-Day market participants generally expect MDX.GN swap pricing to track loss-adjusted risk premium movements in the macro credit markets (CDX spreads). Price volatility and flows related to housing and residential mortgage conditions may influence both CE expectations and loss-adjusted risk premiums — causing changes in the basis between CDX and MDX. These conditions were present in late 2022 when rising interest rates impacted the expected average life of most mortgage obligations originated during COVID. Using the above methodology, today’s MDX.GN CE spreads would fall between 130–150 bps and risk premiums would land between 50–65 bps, resulting in MDX.GN trading spreads of 180–215 bps and swap dollar prices within a point of par.
Cumulative Loss Projections can be used to evaluate MDX.GN pricing assumptions further. Applying the annual CE Spread over the remaining five-year swap term allows pricing spreads to convert to implied CE loss expectations. All the three scenarios are calculated below.
Macro stress and idiosyncratic mortgage stress pricing reflects substantial deterioration of reference borrower Credit Event performance.