While servicing valuations and the various adjusters are the most obvious factors impacting loan execution and pricing, the price spread between different coupons in the same product (i.e., coupon swaps) also play important factors.  We'll take a brief look at coupon swaps, and how they can impact pricing.

The reason that the price differential is called a "swap" is that it can be traded as a single transaction.  In addition to quoting prices on different coupons, dealers will also quote bid and offer prices on the different swaps for coupons in 50 basis point increments.  In trader-talk, to "buy" the swap is to buy the higher coupon and sell the lower coupon; the opposite transaction is considered "selling" the swap.  (As with other transactions involving the relationship between multiple securities, whether you buy or sell the transaction depends on whether you gain or lose from an increase in the transaction's price.)  The markets are quoted in the spread between the two securities; for example, the Fannie 4/3.5 swap can be quoted as 1 28/32s.

It's important to remember that the prices of different coupons do not move in lockstep.  Broadly speaking, this is because the various coupons all have different durations, or sensitivity to changes in rates.  In turn, the duration differences result from different expected prepayment rates.  This is fairly straightforward.  The loans backing the higher-coupon pools have higher note rates and therefore should experience faster prepayments; therefore, the durations of the different coupons (or "coupon stack") typically decline as the coupon increases.

For this reason, swap levels can never be looked at in a vacuum.  For example, as of the end of trading on 4/23 the Fannie 4/3.5 swap was quoted at 1 28/32s (i.e, the price of FN 4s was 1 28/32s over the price of 3.5s).  Over the last 60 days, the average level of the swap has been 1 31/32s.  On that basis alone, you could conclude that the swap is 3/32s cheap to its recent history.

To correctly gauge the price level, however, the coupon swap has to be viewed in context of both time and the level of interest rates.  The charts below shows scatter charts of the coupon swap on the vertical axis versus the yield of the 10-year Treasury on the horizontal axis.  Chart 1 shows the price and rate histories over a long period of time (i.e., to December of 2010),

 Chart 2 shows the same chart using a much shorter look-back period (to September 2011).  The chart also shows linear regression lines generated through Excel; note that the most recent observation is marked with a red data point.

While traders are involved in these swaps all the time, originators don't generally pay much attention to them.  This is probably a mistake.  For example, if the swap is cheap but looks like it is moving back toward more normal levels, it may change the best-execution for some loans from the lower to the higher coupon.  This in turn impacts how originators need to hedge their positions.  For example, if the best-execution for a block of conventional loans with 4.25% note rates changes from FNCL 3.5s to 4s, the lender's position effectively lost a lot of duration; moreover, the lender may eventually have to swap its open commitment from 3.5s into 4s in order to deliver the loans.