Barclays | Residential Credit Trends14 December 2012
What is the fair value of the 06-2 AAA vs. 07-2 PAAA basis?
Estimating the fair value of the basis between these two tranches is more complicated thanit seems at first glance. The 06-2 AAAs and 07-2 PAAAs seem to have similar currentfactors (96-98%) and base case spread durations (~7 years); given the relatively smalldifference in base case tranche losses (as shown in Figure 2), it could be tempting to pricethe basis at equal yields. However, of the 20 bonds in the 06-2 AAAs, we expect 10-12 notto take any tranche losses at all and, as such, over time to trade tighter vs. bonds that dotake losses. On the other hand, in the 07-2 PAAAs, only 2-5 of the 20 bonds can bereasonably expected to have zero losses. As a result, we expect, in equilibrium, the 07-2PAAAs to trade wider than the 06-2 AAAs.So, we measure the basis in two ways. In Figure 4, the first set of columns shows the fairvalue of the basis at various yields on the 06-2 AAAs assuming that the 07-2 PAAAs price100bps wider in equilibrium. The final set of columns shows the basis at equal yields (whichwe think is unlikely given the composition of the indices). Overall the fair value of the basisseems to be in the 8-10 dollar price range which is about 2-4 points tighter vs. currentlevels. In a recovery, as more 07-2 PAAA constituents tend towards a zero loss, this basiscould compress even more to the 4-8 points range and the swap would have more upside.As a result, we recommend going long the 07-2 PAAAs vs. the 06-2 AAAs.FIGURE 4
Fair price spread 06-2 AAA vs. 07-2 PAAA, if 07-2 trades 1% wider/at equal yields (bp)
7-2 PAAA trades1% wider in yield7-2 PAAA tradesat same yield06-2 AAA Yields Stress Base CaseRecoveryStress Base CaseRecovery
3 13.3 10.9 9 8.7 5.8 3.54 11.9 9.8 8.2 7.9 5.2 3.35 10.7 8.8 7.4 7.1 4.7 36 9.6 7.8 6.7 6.3 4.2 2.87 8.6 7 6.1 5.6 3.7 2.5
Source: Barclays Research
TRACE shows non-agency trading volumes significantly up in 2012 vs. 2011
FINRA TRACE data through December 13, 2012, indicate that non-agency trading volumes,excluding IOs, have been $480bn year-to-date, representing average daily trading activity of slightly over $2bn ($1.9bn after excluding the three Maiden Lane II auctions). Thisrepresents a substantial increase over 2011 average daily trading volumes starting in May2011 of $1.4bn (TRACE data on non-agencies were made publicly available only starting onMay 16, 2011). Average monthly non-agency trading volumes of $41bn this year between June and November are also close to 40% higher than the $29.6bn in average monthlytrading activity during the same time frame in 2011. The increase in trading activity thisyear may be a result of the rally in overall risk assets in 2012 and an increase in thesecondary trading of bonds from the Maiden Lane auctions.