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Valuing Mortgage Collateral for
Asset Valuation Purposes
CAE Spring Meeting
June 5, 2009
Prepared by: Michael C. Schmitz, FCAS, MAAA
Principal and Consulting Actuary
mike.schmitz@milliman.com
(262) 796-3322
Agenda
What is a Mortgage Backed Security (MBS)?
Background on the MBS market
Current situation
Valuation modeling
2
What is a Mortgage Backed Security?
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(Pension Fund) (XYZ Ins. Co.)
3
Gross Issuance in US Market
Gross MBS Issuance ($ millions)
$3,000,000
Agency
Total Non‐Agency
$2,500,000
Total MBS
$2,000,000
$1,500,000
$1,000,000
$500,000
$0
Source: Inside MBS & ABS and UBS
4
Agency vs. Non-Agency
MBS Market Share
100%
Agency
90%
Total Non‐Agency
80%
70%
60%
Percent
50%
40%
30%
20%
10%
0%
Source: Inside MBS & ABS and UBS
5
Non-Agency by Type
Non‐Agency Gross MBS Issuance
($ millions)
500,000
Alt‐A
450,000
400,000 Jumbo
350,000 Subprime
300,000 Other
250,000
200,000
150,000
100,000
50,000
0
Source: Inside MBS & ABS and UBS
6
Non-Agency by Type
Non‐Agency
(% of Total MBS Issuance)
25%
Alt‐A
20% Jumbo
Subprime
15% Other
Percent
10%
5%
0%
Source: Inside MBS & ABS and UBS
7
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
8
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
9
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
Source: Federal Reserve Board
3/9/05
5/9/05
7/9/05
9/9/05
11/9/05
1/9/06
Liquidity Evaporated
3/9/06
5/9/06
7/9/06
9/9/06
11/9/06
Mortgage Spread
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
Mortgage Spread (Conventional Mortgage Loan less 10‐year Treasury)
9/9/08
11/9/08
1/9/09
3/9/09
10
Erosion of Market Values – US Market Prices
Real Home Price Index (1890‐2008)
225
200
175
150
125
100
75
50
1890 1910 1930 1950 1970 1990 2010
Source: http://www.econ.yale.edu/~shiller/data.htm
11
100
120
140
160
180
200
220
Jan‐00
Apr‐00
Jul‐00
Oct‐00
Jan‐01
Apr‐01
Source: Standard and Poor's
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
Erosion of Market Values
Oct‐04
Jan‐05
'Case Shiller 20 City Compsite'
Apr‐05
Jul‐05
Oct‐05
Jan‐06
Apr‐06
Jul‐06
Oct‐06
Jul 06: 206.5
Case‐Shiller Home Price Index Since January 2000
Jan‐07
Apr‐07
Jul‐07
Decline: ‐29%
Oct‐07
Jan‐08
Apr‐08
Jul‐08
Oct‐08
Jan 09: 146.4
Jan‐09
12
Erosion of Market Values
ABX HE AAA 2007‐2 Index
80
70
60
50
Price
40
30
20
10
0
Source: Bloomberg
13
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
May 5, 2009 14
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
15
MBS Valuation Flowchart
16
Structure of Mortgage-Backed Securities
Estimate Losses Here
CUSIPS For Cash Flows Here
17
Other Properties of Mortgage-Backed Securities
Interest rate can vary by tranche
• Fixed or floating
Payment Triggers
• Delinquency percentages
• Cumulative losses-to-date
• LIBOR
Distinct collateral groups for difference tranches
Loss patterns similar to XOL insurance
Credit Enhancement
• Mortgage Insurance
• Financial Guarantees
• Excess Interest
• Over Collateralization
18
Other Properties of Mortgage-Backed Securities
19
General Outline of Valuation Process
20
MBS Valuation Process
Collateral
• Extensive history
• Utilize loan level experience
Macro factors
• Home prices
• Interest rates
• Unemployment
21
Model
General Characteristics
• Transparent
• Credit Focus
Prepay model
• Willingness
Interest rate
• Ability
Current LTV
Lending standards/policies
Federal government initiatives
22
Credit Model: amount and timing of loan losses
Key Considerations of Models
• Traditional actuarial development methods can be
used (and in fact are)
Significant limitations to consider
• Methods must critically consider the key drivers of
losses:
Exposure Duration
Underwriting quality of collateral pool
Economic factors affecting collateral pool
Loan level data for each of the above factors
Adjusted BF methods (among others) can do this
23
Ultimate Loss Rate ‘Paid’ LDF
Illustrative Loss Curves ‐ Moody's and Fitch
100%
90%
80%
70%
60%
Percent
Moody's Alt‐A FRM/ARM First Lien
50%
Fitch Prime/Alt‐A
40% Fitch Subprime
30% Moody's Subprime FRM First Lien
20%
10%
0%
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
0
3
6
9
Age (months)
24
Challenges/Pitfalls
Source: Moody’s Subprime RMBS Loss Projection Update, March 5, 2009
25
Challenges/Pitfalls
Source: Moody’s Alt‐A RMBS Loss Projection Update, January 22, 2009
26
A Priori Development - Frequency
Illustrative Loan Characteristics
Amortization
Loan Size FICO‐LTV Prime
Alt‐A
Subprime
Documentation Interest Only
Occupancy Loan Purpose
Property Type
27
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
28
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
29
A Priori Development - Severity
Illustrative Loan Level Severity Distribution
10% 100%
9% 90%
8% 80%
7% 70%
6% 60%
5% 50%
4% 40%
3% 30%
2% 20%
1% 10%
0% 0%
0% 5% 10% 15% 20% 25% 30% 35% 40% 45% 50% 55% 60% 65% 70% 75% 80% 85% 90% 95% 100%
Loan Level Severity
30
MBS Valuation Flowchart
31
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
32
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
33
Other Analytics
Breakpoint graphs
Coverage Ratios
• How many more losses can a tranche handle before
experiencing a principal write-down?
Sensitivity testing
• Defaults
• Prepay
• Severity
34
Estimated Price Range Compared to Market
Prices from Bloomberg
35
Valuing Mortgage Collateral for Asset
Valuation Purposes
Questions?
mike.schmitz@milliman.com
36
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