Actuarial Approach to MBS Valuation

1

May 5, 2009

MORTGAGE BACKED SECURITIES AN ACTUARIAL APPROACH TO

CASH FLOW ANALYSIS

Kyle S. Mrotek, FCAS, MAAANeal Dihora, ASA, CFA

CAS Spring Meeting

May 5, 2009

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May 5, 2009

Agenda

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

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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

Payments

Mor

tgag

e

Paym

ents

MortgageMortgage

Payments

Payments

Sells Servicing Rights

Purchases Jane’s

Mortgage

Purchases John’s

Mortgage

Purchases Jack’s

Mortgage (Payments)

Purchases Sally’s

Mortgage (Payments)

Buys a Portion of M

BS

Buys a Portion of MBS

Cash Flows

Cash Flows

Jane & John’s Payments

May 5, 2009

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May 5, 2009

MBS Valuation Flowchart

Collateral

(Mortgage Loans)

Macro Factors &Assumptions

Prepay /Credit

Models

InterestRate and

HPASimulations

CashFlow

EngineA

BBB

BBB-

Sub

AA

AAA

A

BBB

BBB-

Sub

AA

AAA

LossesLosses

Principal &Interest

Principal &Interest

Data ModelsSecurity Capital

StructureCDO Capital

Structure

Prepay

Default

Loss Severity

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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

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May 5, 2009

Agency vs. Non-Agency

0%

10%

20%

30%

40%

50%

60%

70%

80%

90%

100%

Perc

ent

MBS Market Share

Agency

Total Non-Agency


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May 5, 2009

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

Non-Agency Gross MBS Issuance($ millions)

Alt-A

Jumbo

Subprime

Other


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May 5, 2009

Non-Agency by Type

0%

5%

10%

15%

20%

25%

Perc

ent

Non-Agency (% of Total MBS Issuance)

Alt-A

Jumbo

Subprime

Other


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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

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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

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May 5, 2009

Liquidity Evaporated

100

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

Mortgage SpreadSource: Federal Reserve Board

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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

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May 5, 2009


100

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160

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220

Jan-

00

Apr-0

0

Jul-0

0

Oct

-00

Jan-

01

Apr-0

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Jul-0

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Oct

-01

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-08

Jan-

09

Case-Shiller Home Price Index Since January 2000

'Case Shiller 20 City Compsite'Source: Standard and Poor's

Jul 06: 206.5

Jan 09: 146.4

Decline: -29%

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May 5, 2009


0

10

20

30

40

50

60

70

80

Price

ABX HE AAA 2007-2 Index

Source: Bloomberg

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May 5, 2009


ABX HE AAA 2007-2 Index ComponentsACE Securities Corp. Home Equity Loan Trust, Series 2007-HE4Bear Stearns Asset Backed Securities I Trust 2007-HE3Citigroup Mortgage Loan Trust 2007-AMC2CWABS Asset-Backed Certificates Trust 2007-1 First Franklin Mortgage Loan Trust, Series 2007-FF1GSAMP Trust 2007-NC1 Home Equity Asset Trust 2007-2 HSI Asset Securitization Corporation Trust 2007-NC1 J.P. MORGAN MORTGAGE ACQUISITION TRUST 2007-CH3Merrill 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

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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

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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

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May 5, 2009


Collateral

(Mortgage Loans)


Prepay /Credit

Models

InterestRate and

HPASimulations

CashFlow

EngineA

BBB

BBB-

Sub

AA

AAA

A

BBB

BBB-

Sub

AA

AAA

LossesLosses

Principal &Interest

Principal &Interest



Structure

Prepay

Default

Loss Severity

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May 5, 2009

MBS Valuation Process

Collateral– Extensive history– Utilize loan level experience

Macro factors– Home prices– Interest rates– Unemployment

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May 5, 2009

Model

General Characteristics– Transparent– Credit Focus

Prepay model– Willingness

• Interest rate– Ability

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

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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

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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’

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May 5, 2009

Ultimate Loss Rate ‘Paid’ LDF

0%

10%

20%

30%

40%

50%

60%

70%

80%

90%

100%

0 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

Perc

ent

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)

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May 5, 2009

Ultimate Loss Rate “Incurred” LDF

Incurred losses = ‘paid’ losses + estimate of loss on 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

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May 5, 2009

Challenges/Pitfalls

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

Source: Moody’s March 5, 2009

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May 5, 2009

Challenges/Pitfalls

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

Source: Moody’s January 22, 2009

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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

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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

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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

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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

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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

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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

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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

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May 5, 2009


Collateral

(Mortgage Loans)


Prepay /Credit

Models

InterestRate and

HPASimulations

CashFlow

EngineA

BBB

BBB-

Sub

AA

AAA

A

BBB

BBB-

Sub

AA

AAA

LossesLosses

Principal &Interest

Principal &Interest



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

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May 5, 2009

Cash Flow Waterfall

Illustrative NPV of Cash Flow Waterfall OutputNet 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

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May 5, 2009

MORTGAGE BACKED SECURITIES AN ACTUARIAL APPROACH TO

CASH FLOW ANALYSIS

Questions?

[email protected]@Milliman.com

Actuarial Approach to MBS Valuation

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