Actuarial Approach to Valuing Mortgage Backed Securities

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Actuarial Approach to Valuing Mortgage Backed Securities, presented at the 2009 East Asian Actuarial Conference in Seoul Korea

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Actuarial Approach to Valuing Mortgage Backed Securities

  1. 1. Mortgage-Backed Securities:An Actuarial Approach to Cash Flow ValuationNeal Dihora, ASA, MAAA, CFA Kyle Mrotek, FCAS, MAAA<br />15th East Asian Actuarial Conference<br />Seoul, Korea<br />13 October 2009<br />
  2. 2. Agenda<br />MBS Background<br />Benefits of MBS Valuation<br />Approach to MBS Valuation <br />Closing<br />
  3. 3. U.S. MBS Issuance<br />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<br />Agency securities are sold and guaranteed by the U.S. government<br />Fannie Mae<br />Freddie Mac<br />Ginnie Mae <br />Non-agency securities are not backed by any financial institution<br />Higher risk, higher yield potential<br />Agency securities have regained their popularity<br />
  4. 4. Gross Issuance<br />
  5. 5. Non-Agency by Type<br />
  6. 6. Benefits of MBS Valuation<br /><ul><li>Improve decision making
  7. 7. Improve transparency
  8. 8. Keep up with compliance
  9. 9. Calculate impact on surplus and capital ratios</li></li></ul><li>MBS Valuation Flowchart<br />
  10. 10. Mortgage Models<br />Structural models <br />Focus on underlying dynamics of the mortgage and of trigger events (prepayments and defaults). Do not consider collateral performance to date<br />Borrowers are assumed to exercise the option which is in their best interest<br />Reduced-form models pattern exogenous trigger events with hazard rates or jump processes<br />Actuarial models<br />Focus on forecasting mortgage borrowers’ failure to make timely payments (collateral analysis) <br />Future collateral credit loss can be considered as a function of current loss <br />Cumulative collateral credit loss can be obtained from many sources, for example, consider the MBS, HEAT 2007-2 2A1:<br />
  11. 11.
  12. 12. Actuarial Methods<br /><ul><li>Collateral ‘loss’ projection
  13. 13. Amount and timing
  14. 14. ‘Loss’ is failure to pay timely P&I
  15. 15. Methods
  16. 16. ‘Paid’ Loss Development Factor (LDF)
  17. 17. ‘Incurred’ LDF
  18. 18. ‘Paid’ B-F method
  19. 19. ‘Incurred’ B-F
  20. 20. Non-exhaustive</li></li></ul><li>LDFMethod<br /><ul><li>Paid LDF
  21. 21. Normalize loss to exposure -> loss rate
  22. 22. Ultimate loss = paid loss x cumulative paid LDF
  23. 23. Incurred LDF
  24. 24. Inventory of delinquent loans is used to estimate proxy for case reserves – delinquency status found to be predictive for future performance
  25. 25. Incurred loss equals cumulative paid loss plus proxy for case reserves
  26. 26. Consistent with reserving for mortgage guaranty insurance
  27. 27. Roll rate model = Frequency/Severity method
  28. 28. Frequency = Pr (default | status of delinquency)
  29. 29. Severity (% of loan that is not recoverable)
  30. 30. ‘Incurred’ loss development factors derived from paid loss development factors and distribution of report to pay lag</li></li></ul><li>
  31. 31. Challenges/Pitfalls<br />Source: Moody’s Subprime RMBS Loss Projection Update, March 5, 2009<br />
  32. 32.
  33. 33. Bornhuetter-Ferguson Method<br /><ul><li>More appropriate where loss development is volatile and/or immature
  34. 34. Requires loss to date, a priori loss, and a loss development curve
  35. 35. Future loss indications tend to be heavily weighted toward the a priori loss estimate for recent vintages
  36. 36. A priori loss estimate is key</li></li></ul><li>B-F Method – A Priori<br />A priori ULR development<br /><ul><li>Frequency of default
  37. 37. Severity given default</li></ul>A priori ultimate loss rate = frequency x severity<br />Critical considerations<br /><ul><li>Underwriting characteristics (LTV, documentation, etc.)
  38. 38. Economic factors
  39. 39. Persistency</li></li></ul><li>A Priori Development –Frequency<br />
  40. 40. <ul><li>Loan to value (LTV) is the ratio of original loan balance to purchase price
  41. 41. Higher LTVs indicate less investment in the home by the borrower, and thus, higher propensity to default</li></li></ul><li><ul><li>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
  42. 42. Borrowers who consistently pay less than principal and interest may find their outstanding balance actually increase, raising the likelihood of default </li></li></ul><li><ul><li>Documentation refers to the information provided by the borrower to obtain the loan
  43. 43. Borrowers with full documentation tend to have lower default likelihood than those with low documentation</li></li></ul><li>Economic Factors<br />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<br />
  44. 44. Severity Given Default<br /><ul><li>Severity of Default
  45. 45. Home price changes
  46. 46. Costs of foreclosure (realtor, legal, upkeep)
  47. 47. Accrued interest
  48. 48. Stressed sale
  49. 49. Government intervention may impact severity</li></li></ul><li>B-F Method<br /><ul><li>Paid B-F Method
  50. 50. Paid loss to date
  51. 51. Paid LDFs
  52. 52. A priori loss
  53. 53. Estimates future paid loss
  54. 54. Incurred B-F
  55. 55. Paid loss to date plus proxy for case reserves = Incurred loss
  56. 56. ‘Incurred’ LDFs
  57. 57. A priori loss
  58. 58. Estimates future paid loss on non-delinquent loans</li></li></ul><li>MBS Valuation Flowchart<br />
  59. 59. Risk Quantification<br />
  60. 60. Closing<br /><ul><li>Credit risk previously overlooked
  61. 61. Credit risk exists
  62. 62. Activities positioned to analyze credit risk
  63. 63. Large MBS holders include banks, insurance companies, asset managers
  64. 64. Benefits to accurate MBS valuations</li></li></ul><li>Mortgage-Backed Securities: An Actuarial Approach to Cash Flow Valuation<br />Questions?<br />kyle.mrotek@milliman.comneal.dihora@milliman.com<br />

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