actuarial approach to valuing mortgage backed securities
DESCRIPTION
Actuarial Approach to Valuing Mortgage Backed Securities, presented at the 2009 East Asian Actuarial Conference in Seoul KoreaTRANSCRIPT
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Mortgage-Backed Securities:An Actuarial Approach to
Cash Flow Valuation
Neal Dihora, ASA, MAAA, CFA Kyle Mrotek, FCAS, MAAA
15th East Asian Actuarial Conference
Seoul, Korea
13 October 2009
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Agenda
MBS Background
Benefits of MBS Valuation
Approach to MBS Valuation
Closing
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U.S. MBS Issuance
A mortgage-backed security is a debt obligation that transfers cash flows from borrowers who have purchased homes to investors looking for a higher yield than government bonds
Agency securities are sold and guaranteed by the U.S. government– Fannie Mae
– Freddie Mac
– Ginnie Mae
Non-agency securities are not backed by any financial institution– Higher risk, higher yield potential
Agency securities have regained their popularity
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Gross Issuance
$0.0
$0.5
$1.0
$1.5
$2.0
$2.5
$3.0
US Gross MBS Issuance ($ trillions)
Agency
Total Non-Agency
Total MBS
Source: Inside MBS & ABS , SIFMA and UBS
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Non-Agency by Type
0
50,000
100,000
150,000
200,000
250,000
300,000
350,000
400,000
450,000
500,000
US Non-Agency Gross MBS Issuance($ millions)
Alt-A
Jumbo
Subprime
Other
Source: Inside MBS & ABS , SIFMA and UBS
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Benefits of MBS Valuation
Improve decision making
Improve transparency
Keep up with compliance
Calculate impact on surplus and capital ratios
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MBS Valuation Flowchart
Collateral(Mortgage Loans )
Performance to date
Underwriting Characteristics
EconomicForecasts
Credit /PrepayModel
SecurityCapital
Structure
Losses
Principal &Interest
Data Models Future Cash Flows
Future
Collateral
Performance Assumptions
Subordinate
Equity
Mezzanine
Senior
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Mortgage Models Structural models
– Focus on underlying dynamics of the mortgage and of trigger events (prepayments and defaults). Do not consider collateral performance to date
– Borrowers are assumed to exercise the option which is in their best interest
Reduced-form models pattern exogenous trigger events with hazard rates or jump processes
Actuarial models– Focus on forecasting mortgage borrowers’ failure to make timely payments
(collateral analysis)
– Future collateral credit loss can be considered as a function of current loss
– Cumulative collateral credit loss can be obtained from many sources, for example, consider the MBS, HEAT 2007-2 2A1:
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Actuarial Methods
Collateral ‘loss’ projection– Amount and timing
– ‘Loss’ is failure to pay timely P&I
Methods– ‘Paid’ Loss Development Factor (LDF)
– ‘Incurred’ LDF
– ‘Paid’ B-F method
– ‘Incurred’ B-F
– Non-exhaustive
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LDF Method Paid LDF
– Normalize loss to exposure -> loss rate
– Ultimate loss = paid loss x cumulative paid LDF
Incurred LDF– Inventory of delinquent loans is used to estimate proxy for case reserves –
delinquency status found to be predictive for future performance
– Incurred loss equals cumulative paid loss plus proxy for case reserves
– Consistent with reserving for mortgage guaranty insurance
– Roll rate model = Frequency/Severity method
– Frequency = Pr (default | status of delinquency)
– Severity (% of loan that is not recoverable)
– ‘Incurred’ loss development factors derived from paid loss development factors and distribution of report to pay lag
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Challenges/Pitfalls
Source: Moody’s Subprime RMBS Loss Projection Update, March 5, 2009
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Case-Shiller Home Price Index Since January 2000
'Case Shiller 20 City Compsite'Source: Standard and Poor's
Jul06: 206.5
Apr 09: 139.2
Decline: -32.6%
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Bornhuetter-Ferguson Method
More appropriate where loss development is volatile and/or immature
Requires loss to date, a priori loss, and a loss development curve
Future loss indications tend to be heavily weighted toward the a priori loss estimate for recent vintages
A priori loss estimate is key
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B-F Method – A Priori
A priori ULR development– Frequency of default
– Severity given default
A priori ultimate loss rate = frequency x severity
Critical considerations– Underwriting characteristics (LTV, documentation, etc.)
– Economic factors
– Persistency
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A Priori Development – Frequency
Amortization
FICO-LTV
Interest Only
Loan Purpose
Property Type
Occupancy
Documentation
Loan Size
Illustrative Loan Characteristics
Prime
Alt-A
Subprime
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Loan to value (LTV) is the ratio of original loan balance to purchase price
Higher LTVs indicate less investment in the home by the borrower, and thus, higher propensity to default
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Loans are available in which the borrower has the option to pay less than the principal and interest needed to completely amortize the loan over its amortization period
Borrowers who consistently pay less than principal and interest may find their outstanding balance actually increase, raising the likelihood of default
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Documentation refers to the information provided by the borrower to obtain the loan
Borrowers with full documentation tend to have lower default likelihood than those with low documentation
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Economic Factors
Source: “Negative equity and foreclosure: Theory and evidence”, Christopher L. Foote, Kristopher Gerardi, Paul S. Willen, Journal of Urban Economics 64 (2008), pp. 234-345
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Severity Given Default
Severity of Default– Home price changes– Costs of foreclosure (realtor, legal, upkeep)– Accrued interest– Stressed sale– Government intervention may impact severity
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B-F Method
Paid B-F Method– Paid loss to date
– Paid LDFs
– A priori loss
– Estimates future paid loss
Incurred B-F– Paid loss to date plus proxy for case reserves = Incurred loss
– ‘Incurred’ LDFs
– A priori loss
– Estimates future paid loss on non-delinquent loans
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MBS Valuation Flowchart
Collateral(Mortgage Loans )
Performance to date
Underwriting Characteristics
EconomicForecasts
Credit /PrepayModel
SecurityCapital
Structure
Losses
Principal &Interest
Data Models Future Cash Flows
Future
Collateral
Performance Assumptions
Subordinate
Equity
Mezzanine
Senior
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Risk Quantification
0
20
40
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100
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0 5 10 15 20 25 30 35 40 45 50 55 60 65 70 75 80 85 90 95 100
Intr
insi
c V
alue
Ultimate Loss Rate
Sensitivity of HEAT 2007-2 2A4with Increasing Ultimate Loss Rates
Breakpoint
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Closing
Credit risk previously overlooked Credit risk exists Activities positioned to analyze credit risk Large MBS holders include banks, insurance companies, asset
managers Benefits to accurate MBS valuations
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Mortgage-Backed Securities: An Actuarial Approach to
Cash Flow Valuation
Questions?
[email protected]@milliman.com