Today’s forecast for U.S. Treasury yields is based on the December 27, 2012 constant maturity Treasury yields that were reported by the Board of Governors of the Federal Reserve System in its H15 Statistical Release at 4:15 p.m. Eastern Standard Time December 28, 2012. The forecast for primary mortgage market yields and the resulting mortgage servicing rights valuations are derived in part from the Federal Home Loan Mortgage Corporation Primary Mortgage Market Survey ® made available on the same day.

The U.S. Treasury “forecast” is the implied future coupon bearing U.S. Treasury yields derived using the maximum smoothness forward rate smoothing approach developed by Adams and van Deventer (*Journal of Fixed Income*, 1994) and corrected in van Deventer and Imai,* Financial Risk Analytics* (1996). The primary mortgage yield forecast applies the maximum smoothness approach to primary mortgage market credit spreads, which embed the risk neutral probabilities of mortgage default and prepayment risk. References explaining this approach are given below.

Both forecasts, plus the mortgage servicing rights parameters, are available via Kamakura Risk Information Services: Treasury Yield Service, Mortgage Yield Service, and MSR Valuation Service. For information, please contact Kamakura Corporation at info@kamakuraco.com. Similar forecasts for the marginal cost of bank funding and the Libor-swap curve are also available on request.

U.S. Treasury Yield Forecast

This week’s projections for the 1 month Treasury bill rate (investment basis) produce a curve that is slightly flatter than last week, as shown below. The projected 1 month rate of 3.522% in November 2022 is up 6 basis points from last week. The 10 year U.S. Treasury yield is projected to rise steadily to reach 3.477% on November 30, 2022, 12 basis points lower than projected last week.

**Mortgage Valuation Yield Curve and Mortgage Yield Forecast**

The zero coupon yield curve appropriate for valuing mortgages in the primary mortgage market is derived from new issue effective yields reported by the Federal Home Loan Mortgage Corporation in its Primary Mortgage Market Survey ®. The maximum smoothness credit spread is produced so that this spread, in combination with the U.S. Treasury curve derived above, correctly values new 15 year and 30 year fixed rate mortgages at their initial principal value less the value of points. The next graph compares the implied 15 year fixed rate mortgage yield with the implied 15 year U.S. Treasury fixed rate amortizing yield over the next ten years.

The effective yield on 15 year fixed rate mortgages is projected to rise from 2.75% today to 4.486% in 10 years, up 8 basis points compared to last week. The 15 year fixed rate mortgage spread over 15 year amortizing Treasury yields is forecasted to narrow from its current level of 1.11% to 0.979% in 10 years, down 7 basis points from last week.

Implied Valuation of Mortgage Servicing Rights

Using the insights of Kamakura Managing Director of Research Prof. Robert Jarrow noted below, we have derived the risk-neutral values of mortgage cash flows which are based on market implied default risk and prepayment risk. We use these zero coupon bond prices to value mortgage-related cash flows relevant to mortgage servicing rights. These zero coupon bond prices, when multiplied by current primary mortgage market terms, value new mortgages at their principal value less the value of points:

Today’s implied mortgage valuation yield curve results in the following risk-neutral valuation split between interest-only and principal-only cash flows:

We apply the same mortgage valuation yield curve zero coupon bond prices to various levels of net servicing fees to get their risk-neutral present value in today’s market:

If we use the market convention that the net cost to service is a constant dollar amount, the risk-neutral present value of the net cost to service can be derived using the same zero coupon bond prices from the mortgage valuation yield curve.

Kamakura Corporation works with clients on a consulting basis to do this valuation on a risk-neutral inflation adjusted basis as well as the constant nominal dollar cost basis.

Next, we value float per $100 of taxes and insurance on the underlying home. We assume that float is invested at the matched maturity U.S. Treasury forward rate for the matching float period below. The risk-neutral present value of the interest earned is calculated using the mortgage valuation yield curve, since an event of default or prepayment on the underlying mortgage ends this source of value. Value for a constant $100 amount is given here for “float periods” ranging from 1/4 of a month to a full month:

Again, the same analysis can be done on an inflation adjusted basis with insurance and taxes tied to the value of the home.

The value of float on the payment of interest and principal for various lengths of the “float period” is given in this table:

Another important component of mortgage servicing rights valuation is the net impact of cash flows to the servicer from the events of default and prepayment. We can analyze this by asking this question: what would be the value of the mortgage if there were no events of default or prepayment? The answer is obtained by applying U.S Treasury zero coupon bond rates to the scheduled mortgage cash flows. This table shows the net reduction in certain monthly cash flow that would be necessary for the value of the mortgage to adjust downward from this “no default/no prepayment value” to its current market value, discounted by the U.S. Treasury zero coupon bond prices. This adjusted basis converts the random probability of losses from prepayment and default to a known, certain cost of prepayment and default in the form of this “implied net constant monthly cash flow reduction.” The division of this negative cash flow impact between the servicer and other parties depends on the term of the servicing contract:

**Background Information on Input Data and Smoothing**

The Federal Reserve H15 statistical release is available here:

http://www.federalreserve.gov/Releases/H15/Update/

The maximum smoothness forward rate approach to yield curve smoothing was described in this blog entry:

van Deventer, Donald R., “Basic Building Blocks of Yield Curve Smoothing, Part 10: Maximum Smoothness Forward Rates and Related Yields versus Nelson-Siegel,” Kamakura blog, www.kamakuraco.com, January 5, 2010. Redistributed on www.riskcenter.com on January 7, 2010.

The use of the maximum smoothness forward rate approach for bond data is discussed in this blog entry:

van Deventer, Donald R., “Basic Building Blocks of Yield Curve Smoothing, Part 12: Smoothing with Bond Prices as Inputs,” Kamakura blog, www.kamakuraco.com, January 20, 2010. Redistributed on www.riskcenter.com on January 21, 2010.

The reasons for smoothing forward credit spreads instead of the absolute level of forward rates for the marginal bank funding cost curve were discussed in this blog entry:

van Deventer, Donald R., “Basic Building Blocks of Yield Curve Smoothing, Part 13: Smoothing Credit Spreads,” Kamakura blog, www.kamakuraco.com, April 7, 2010. Redistributed on www.riskcenter.com, April 14, 2010.

The Kamakura approach to interest rate forecasting was introduced in this blog entry:

van Deventer, Donald R., “The Kamakura Corporation Monthly Forecast of U.S. Treasury Yields,” Kamakura blog, www.kamakuraco.com, March 31, 2010. Redistributed on www.riskcenter.com on April 1, 2010.

The problems with conventional approaches to mortgage servicing rights valuation are outlined in this blog entry:

Slattery, Mark and Donald R. van Deventer, “Model Risk in Mortgage Servicing Rights,” Kamakura blog, www.kamakuraco.com, December 5, 2011.

Kamakura’s approach to mortgage valuation yield curve derivation was first outlined in this blog entry:

van Deventer, Donald R., “A Simple, Transparent and Accurate Mortgage Valuation Yield Curve That Does Not Rely on Libor,” Kamakura blog, www.kamakuraco.com, August 28, 2012.

The academic paper outlining the Kamakura approach to mortgage yield curve derivation has been submitted and accepted for publication by a prestigious academic journal:

Jarrow, Robert A. and Donald R. van Deventer, “A Simple, Transparent and Accurate Mortgage Valuation Yield,” forthcoming, 2013.

The mortgage valuation yield curve insights depend heavily on this important paper:

Jarrow, Robert A., “Risky Coupon Bonds as a Portfolio of Zero-Coupon Bonds,” Finance Research Letters, 1, no. 2 (June, 2004) pp. 100–105.

**Today’s Kamakura U.S. Treasury Yield Forecast**

The Kamakura 10 year monthly forecast of U.S. Treasury yields is based on this data from the Federal Reserve H15 statistical release:

The graph below shows in 3 dimensions the movement of the U.S. Treasury yield curve 120 months into the future at each month end:

These yield curve movements are consistent with the continuous forward rates and zero coupon yields implied by the U.S. Treasury coupon bearing yields above:

In numerical terms, forecasts for the first 60 months of U.S. Treasury yield curves are as follows:

The forecasted yields for months 61 to 120 are given here:

**Today’s Kamakura Forecast for Effective Primary Mortgage Market Yields**

Today’s forecast for the mortgage valuation yield curve is based on the following data from the Federal Home Loan Mortgage Corporation Primary Mortgage Market Survey ®:

Only fixed rate mortgage data is used in this analysis for reasons explained in the Kamakura mortgage valuation blog.

Applying the maximum smoothness forward rate smoothing approach to the forward credit spreads between the mortgage valuation yield curve and the U.S. Treasury curve results in the following zero coupon bond yields:

The forward rates for the mortgage valuation yield curve and U.S. Treasury curve are shown here:

The numerical values for 360 months of zero coupon bond prices and yields for the mortgage valuation yield curve are available by subscription to the KRIS Mortgage Yield Service via info@kamakuraco.com. For comments, questions, or more information about the yield curve smoothing and simulation capabilities in Kamakura Risk Manager, please contact us at info@kamakuraco.com. Kamakura interest rate data are available in electronic form in both general and Kamakura Risk Manager data base format.

Taqui Raza, Donald R. van Deventer and Martin Zorn

Kamakura Corporation

Honolulu, December 28, 2012

Copyright © Kamakura Corporation, 2012. All Rights Reserved.