With the headline risk surrounding Freddie Mac and Fannie Mae, investors are beginning to question the credit quality of agency MBS. With this in mind, Deutsche Bank calculated the default risk in this sector, and concluded that it was minimal.

Deutsche measured agency MBS default risk by taking into account the increased probability of default of agencies that is implied from the debt markets as well as expected defaults in MBS.

Freddie subordinated debt widened by as much as 30 basis points at the peak of investor concern. Deutsche stated that, considering GSE assets are comprised mainly of securities, an 80% recovery value could be considered reasonable and would allow ample room for the assets to cheapen. The firm said that the 20 basis points of subordinated debt widening and an 80% recovery value suggests an increased likelihood of default of 37.5 basis points.

Deutsche noted that the expected annual loss on mortgage-backeds is approximately equal to the annual GSE guarantee fee, which is about 25 basis points. Thus the increased cost of default in agency MBS, utilizing the increased cost of default suggested by the Freddie subordinated debt at its widest levels over the previous week, would be the product of 37.5 basis points multiplied by 25 basis points. The resulting number is 0.09 basis points.

There is clearly the possibility that if Fannie or Freddie were to fail, this would cause house prices to fall and the annual loss on MBS to increase. But Deutsche said that even with losses at 10 times the levels anticipated in the analysis shown, the overall effect would still be less than a basis point. Analysts noted that small changes in prepayment models often cause moves of three to four basis points in OAS.

"Hence, we truly feel that MBS are a safe investment from a credit perspective and that other factors are far more important in the investment decision," wrote analysts. "Indeed, the result of a collapse of the agency system would likely be more damaging to MBS from a liquidity perspective than a credit perspective."

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