MORTGAGE BACKED SECURITIES AN ACTUARIAL APPROACH TO CASH FLOW - - PowerPoint PPT Presentation

1 May 5, 2009

MORTGAGE BACKED SECURITIES AN ACTUARIAL APPROACH TO CASH FLOW ANALYSIS

Kyle S. Mrotek, FCAS, MAAA Neal Dihora, ASA, CFA

CAS Spring Meeting May 5, 2009

2 May 5, 2009

Agenda

• What is a Mortgage Backed Security (MBS)?
• Background on the MBS market
• Current situation
• Actuarial model presentation

3

What is a Mortgage Backed Security?

Investor B

(XYZ Ins. Co.)

Investor A

(Pension Fund)

MBS Issuer/ Trustee Originator A

(Retains Servicing)

Originator B Servicer Jack Sally Jane John

Mortgage Jane & John’s Payments May 5, 2009

4 May 5, 2009

MBS Valuation Flowchart

Collateral (Mortgage Loans) Macro Factors & Assumptions Prepay / Credit Models Interest Rate and HPA Simulations Cash Flow Engine A BBB BBB- Sub AA AAA A BBB BBB- Sub AA AAA

Losses Losses Principal & Interest Principal & Interest

Data Models

Security Capital Structure CDO Capital Structure Prepay Default Loss Severity

5 May 5, 2009

Gross Issuance

$0 $500,000 $1,000,000 $1,500,000 $2,000,000 $2,500,000 $3,000,000

Gross MBS Issuance ($ millions)

Agency Total Non-Agency Total MBS

Source:Inside MBS & ABS and UBS

6 May 5, 2009

Agency vs. Non-Agency

0% 10% 20% 30% 40% 50% 60% 70% 80% 90% 100% Percent

MBS Market Share

Agency Total Non-Agency

Source: Inside MBS & ABS and UBS

7 May 5, 2009

Non-Agency by Type

50,000 100,000 150,000 200,000 250,000 300,000 350,000 400,000 450,000 500,000

Non-Agency Gross MBS Issuance ($ millions)

Alt-A Jumbo Subprime Other

Source: Inside MBS & ABS and UBS

8 May 5, 2009

Non-Agency by Type

0% 5% 10% 15% 20% 25% Percent

Non-Agency (% of Total MBS Issuance)

Alt-A Jumbo Subprime Other

Source: Inside MBS & ABS and UBS

9 May 5, 2009

Current Situation

• What happened?
• Liquidity evaporated
• Market values eroded
• Why is valuation needed?
• GAAP Accounting regulations still require a value (FAS 157)
• Risk quantification
• Distribution of assumptions and valuations

10 May 5, 2009

Liquidity Evaporated

• Broker/Dealers of non-Agency MBS unwilling to

provide liquidity 1

• Forced liquidations of MBS set market prices 1
• Pricing vendors find it difficult to obtain “real” prices
• Bid - Ask spread is 10-30 points depending on

collateral and the depth of distress 2

1AD&Co's 16th Annual Conference: The Times They Are A-Changin‘ 2”Getting Out of the Mess” by Dave Hurt at the Loan Performance Symposium March 11, 2009

11 May 5, 2009

Liquidity Evaporated

100 120 140 160 180 200 220 240 260 280 300 1/9/04 3/9/04 5/9/04 7/9/04 9/9/04 11/9/04 1/9/05 3/9/05 5/9/05 7/9/05 9/9/05 11/9/05 1/9/06 3/9/06 5/9/06 7/9/06 9/9/06 11/9/06 1/9/07 3/9/07 5/9/07 7/9/07 9/9/07 11/9/07 1/9/08 3/9/08 5/9/08 7/9/08 9/9/08 11/9/08 1/9/09 3/9/09

Mortgage Spread (Conventional Mortgage Loan less 10-year Treasury)

Mortgage Spread

Source: Federal Reserve Board

12 May 5, 2009

Erosion of Market Values

50 75 100 125 150 175 200 225 1890 1910 1930 1950 1970 1990 2010

Real Home Price Index (1890-2008)

Source: http://www.econ.yale.edu/~shiller/data.htm

13 May 5, 2009

Erosion of Market Values

100 120 140 160 180 200 220 Jan-00 Apr-00 Jul-00 Oct-00 Jan-01 Apr-01 Jul-01 Oct-01 Jan-02 Apr-02 Jul-02 Oct-02 Jan-03 Apr-03 Jul-03 Oct-03 Jan-04 Apr-04 Jul-04 Oct-04 Jan-05 Apr-05 Jul-05 Oct-05 Jan-06 Apr-06 Jul-06 Oct-06 Jan-07 Apr-07 Jul-07 Oct-07 Jan-08 Apr-08 Jul-08 Oct-08 Jan-09

Case-Shiller Home Price Index Since January 2000

'Case Shiller 20 City Compsite'

Source: Standardand Poor's Jul06: 206.5 Jan 09: 146.4 Decline: -29%

14 May 5, 2009

Erosion of Market Values

10 20 30 40 50 60 70 80 Price

ABX HE AAA 2007-2 Index

Source: Bloomberg

15 May 5, 2009

Erosion of Market Values

• ABX HE AAA 2007-2 Index Components

ACE Securities Corp. Home Equity Loan Trust, Series 2007-HE4 Bear Stearns Asset Backed Securities I Trust 2007-HE3 Citigroup Mortgage Loan Trust 2007-AMC2 CWABS Asset-Backed Certificates Trust 2007-1 First Franklin Mortgage Loan Trust, Series 2007-FF1 GSAMP Trust 2007-NC1 Home Equity Asset Trust 2007-2 HSI Asset Securitization Corporation Trust 2007-NC1 J.P. MORGAN MORTGAGE ACQUISITION TRUST 2007-CH3 Merrill Lynch First Franklin Mortgage Loan Trust, Series 2007-2 MERRILL LYNCH MORTGAGE INVESTORS TRUST, SERIES 2007-MLN1 Morgan Stanley ABS Capital I Inc. Trust 2007-NC3 Nomura Home Equity Loan, Inc., Home Equity Loan Trust Series 2007-2 NovaStar Mortgage Funding Trust, Series 2007-2 OPTION ONE MORTGAGE LOAN TRUST 2007-5 RASC Series 2007-KS2 Trust Securitized Asset Backed Receivables LLC Trust 2007-BR4 Structured Asset Securities Corporation Mortgage Loan Trust 2007-BC1 SOUNDVIEW HOME LOAN TRUST 2007-OPT1 WaMu Asset-Backed Certificates WaMu Series 2007-HE2 Source: markit.com 3/16/09

16 May 5, 2009

GAAP Valuation Still Needed

• Mark to Market

– FAS 157 required companies to value holdings

• Level 1 – based on market price

– Recent observed prices could be due to forced liquidation

• Level 2 – based on related price (ex. spread to treasuries)

– Spreads can reflect lots of different risks (credit, liquidity,…)

• Level 3 – based on model price
• Mark to Model pricing developed from loan level data

– FASB relaxation of mark-to-market rules – FAS 157-4 and FAS 115-2 – Perhaps an ‘intrinsic value’ based on full range of scenarios

17 May 5, 2009

GAAP Valuation Still Needed

• FAS 157 –Level 3 assets as % of tangible common equity

18 May 5, 2009

Risk Quantification

• The following table has daily percent changes of

DJIA under a Normal Distribution assumption and reality

Percent Move (1916-2003) Normal Distribution Assumption Reality <>3.4% 58 1001 <>4.5% 6 366 <>7% 1 in 300,000 years 48

Source: Benoit Mandelbrot, Economist 1/24/2009

19 May 5, 2009

MBS Valuation Flowchart

Collateral (Mortgage Loans) Macro Factors & Assumptions Prepay / Credit Models Interest Rate and HPA Simulations Cash Flow Engine A BBB BBB- Sub AA AAA A BBB BBB- Sub AA AAA

Losses Losses Principal & Interest Principal & Interest

Data Models

Security Capital Structure CDO Capital Structure Prepay Default Loss Severity

20 May 5, 2009

MBS Valuation Process

• Collateral

– Extensive history – Utilize loan level experience

• Macro factors

– Home prices – Interest rates – Unemployment

21 May 5, 2009

Model

• General Characteristics

– Transparent – Credit Focus

• Prepay model

– Willingness

• Interest rate

– Ability

• Current LTV
• Lending standards/policies
• Federal government initiatives

22 May 5, 2009

Credit Model

• Collateral ‘loss’ projection

– Amount and timing – ‘Loss’ is failure to pay timely P&I

• Methods

– ‘Paid’ Loss Development Factor (LDF) – ‘Incurred’ LDF – Adjusted ‘paid’ BF method – ‘Incurred’ BF – Non-exhaustive

23 May 5, 2009

Ultimate Loss Rate ‘Paid’ LDF

• Ultimate loss rate (ULR)
• ‘Paid’ losses to date

–

Can calculate from loan level data

–

Data aggregators

• Cumulative loss curve by age of loan

–

Reciprocal of cumulative LDF

–

Examples on next slide

–

What % of the losses should we expect to see at a certain loan age

• Ultimate loss = ‘paid’ losses / % expected to be ‘paid’

24 May 5, 2009

Ultimate Loss Rate ‘Paid’ LDF

0% 10% 20% 30% 40% 50% 60% 70% 80% 90% 100% 3 6 9 12 15 18 21 24 27 30 33 36 39 42 45 48 51 54 57 60 63 66 69 72 75 78 81 84 87 90 93 96 99 102 105 108 111 114 117 120 Percent

Illustrative Loss Curves - Moody's and Fitch

Moody's Alt-A FRM/ARM First Lien Fitch Prime/Alt-A Fitch Subprime Moody's Subprime FRM First Lien

Age (months)

25 May 5, 2009

Ultimate Loss Rate “Incurred” LDF

• Incurred losses = ‘paid’ losses + estimate of loss
• n inventory of delinquent loans
• Roll rate model = Frequency/Severity method
• Frequency = Pr( default | status of delinquency)
• Severity (% of loan that is not recoverable)
• Utilize incurred loss curves to calculate ultimate

loss rate

• Challenges/pitfalls

26 May 5, 2009

Challenges/Pitfalls

Source: Moody’s Subprime RMBS Loss Projection Update, March 5, 2009 Source: Moody’s March 5, 2009

27 May 5, 2009

Challenges/Pitfalls

Source: Moody’s Alt-A RMBS Loss Projection Update, January 22, 2009 Source: Moody’s January 22, 2009

28 May 5, 2009

B/F Method

• A Priori ULR Development
• Frequency of default
• Severity given default
• Unadjusted a priori ultimate loss rate = frequency

x severity

• Critical considerations for loan level collateral
• Underwriting characteristics (FICO, LTV, documentation, etc.)
• Economic factors

29 May 5, 2009

A Priori Development - Frequency

Amortization FICO-LTV Interest Only Loan Purpose Property Type Occupancy Documentation Loan Size

Illustrative Loan Characteristics

Prime Alt-A Subprime

30 May 5, 2009

A Priori Development - Frequency

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

31 May 5, 2009

A Priori Development - Severity

• Severity of Default

–

Home price changes

–

Costs of foreclosure (realtor, legal, upkeep)

–

Accrued interest

–

Stressed sale

–

Government intervention may impact severity

32 May 5, 2009

A Priori Development - Severity

0% 1% 2% 3% 4% 5% 6% 7% 8% 9% 10% 0% 5% 10% 15% 20% 25% 30% 35% 40% 45% 50% 55% 60% 65% 70% 75% 80% 85% 90% 95% 100% 0% 10% 20% 30% 40% 50% 60% 70% 80% 90% 100% Loan Level Severity

Illustrative Loan Level Severity Distribution

33 May 5, 2009

Ultimate Loss Rate Adjusted Paid BF

• Paid losses to date
• A priori persistency adjustment

– Actual persistency = unpaid balance / original balance – A priori persistency = anticipated unpaid balance / original balance – Adjustment needed to allow for more/less losses based on actual vs.

anticipated exposure duration

• Adjust a priori ultimate loss rate by persistency

factor

• Use loss curve to estimate % yet to be paid

34 May 5, 2009

Ultimate Loss Rate “Incurred” BF

• Utilize incurred loss curve
• Take a priori ultimate loss rate (from a priori

development)

– Utilize incurred loss curves to estimate % yet to be paid

• Incurred BF ultimate loss = incurred to date +

estimate of yet to be incurred

35 May 5, 2009

MBS Valuation Flowchart

Collateral (Mortgage Loans) Macro Factors & Assumptions Prepay / Credit Models Interest Rate and HPA Simulations Cash Flow Engine A BBB BBB- Sub AA AAA A BBB BBB- Sub AA AAA

Losses Losses Principal & Interest Principal & Interest

Data Models

Security Capital Structure CDO Capital Structure Prepay Default Loss Severity

36 May 5, 2009

Cash Flow Waterfall

• MBS intrinsic value = NPV (future security CFs)
• Future security CFs = f(mortgage collateral

performance, structure)

– Which security gets how much when depends on cash

flow amounts and timing and triggers

– Various triggers

37 May 5, 2009

Cash Flow Waterfall

Illustrative NPV of Cash Flow Waterfall Output

Net Present Value (NPV) RMBS Tranche Original Rating Scenario 1 Scenario 2 Scenario 3 A AAA 99.71 99.66 99.70 B AAA 77.63 78.52 69.03 C AA 79.09 7.81 1.64 D AA 78.64 9.96 1.66 E A 80.16 2.79 0.70 F BBB 86.83 0.64 0.39 G BBB 85.62 0.49 0.39 H BB 0.94 0.40 0.39 I BB 0.78 0.40 0.39 J Not Rated 5.46 5.34 0.39 K Not Rated 0.40 0.40 0.39

38 May 5, 2009

MORTGAGE BACKED SECURITIES AN ACTUARIAL APPROACH TO CASH FLOW ANALYSIS Questions?

Kyle.Mrotek@Milliman.com Neal.Dihora@Milliman.com