Sunday, April 20, 2008

Jumbo Conforming Spread

I was looking at the Wells Fargo mortgage web page this morning. The jumbo conforming spread for prime mortgages is around 125 basis points. The spread implies an expected default probability for jumbos, and so I started fooling around with a few simulations.

I used the following assumptions: 12 percent prepayment each year, 30 year term, jumbo rate of 7.35 percent; conforming rate of 6.1 percent, constant conditional default rate (this is the least realistic); loss rate conditional on default of 35 percent. Given these assumptions, the implied conditional default rate is in excess of 3 percent per year, which is extraordinarily high for prime mortgages.

If I raise loss conditional on default to .5, the implied expected default rate becomes 2.5 percent per year. I will do further refining of this, but it seems to me that prime jumbo mortgages are a good investment opportunity.

3 comments:

Anonymous said...

the dangerous assumption is the 12% CPR. What happens if spreads suddenly revert to normal and they rapidly prepay?

Anonymous said...

^^Thanks!!

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