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

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 1 May 5, 2009

Agenda  What is a Mortgage Backed Security (MBS)?  Background on the MBS market  Current situation  Actuarial model presentation 2 May 5, 2009

What is a Mortgage Backed Security? Jack Jane John Sally Mortgage Servicer Jane & Originator A Originator B John’s (Retains Servicing) Payments MBS Issuer/ Trustee Investor B Investor A (XYZ Ins. Co.) (Pension Fund) 3 May 5, 2009

MBS Valuation Flowchart CDO Capital Security Capital Models Structure Data Structure Principal & Principal & Interest Interest AAA AAA Prepay / Collateral Credit Models (Mortgage Loans) AA AA Prepay Cash Default Flow A A Interest Loss Severity Engine Rate and BBB BBB HPA BBB- BBB- Simulations Sub Sub Losses Losses Macro Factors & Assumptions 4 May 5, 2009

Gross Issuance 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 5 May 5, 2009

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 6 May 5, 2009

Non-Agency by Type Non-Agency Gross MBS Issuance ($ millions) 500,000 Alt-A 450,000 Jumbo 400,000 Subprime 350,000 300,000 Other 250,000 200,000 150,000 100,000 50,000 0 Source: Inside MBS & ABS and UBS 7 May 5, 2009

Non-Agency by Type Non-Agency (% of Total MBS Issuance) 25% Alt-A Jumbo 20% Subprime 15% Other Percent 10% 5% 0% Source: Inside MBS & ABS and UBS 8 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 9 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 1 AD&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 10 May 5, 2009

Liquidity Evaporated Mortgage Spread (Conventional Mortgage Loan less 10-year Treasury) 300 280 260 240 220 200 180 160 140 120 100 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 Source: Federal Reserve Board 11 May 5, 2009

Erosion of Market Values 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 12 May 5, 2009

Erosion of Market Values Case-Shiller Home Price Index Since January 2000 220 Jul06: 206.5 200 180 Decline: -29% 160 Jan 09: 146.4 140 120 100 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 Source: Standardand Poor's 'Case Shiller 20 City Compsite' 13 May 5, 2009

Erosion of Market Values ABX HE AAA 2007-2 Index 80 70 60 50 Price 40 30 20 10 0 Source: Bloomberg 14 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 15 Source: markit.com 3/16/09 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 16 May 5, 2009

GAAP Valuation Still Needed  FAS 157 –Level 3 assets as % of tangible common equity 17 May 5, 2009

Risk Quantification  The following table has daily percent changes of DJIA under a Normal Distribution assumption and reality Percent Move Normal (1916-2003) Distribution Assumption Reality <>3.4% 58 1001 <>4.5% 6 366 <>7% 1 in 300,000 years 48 18 Source: Benoit Mandelbrot, Economist 1/24/2009 May 5, 2009

MBS Valuation Flowchart CDO Capital Security Capital Models Structure Data Structure Principal & Principal & Interest Interest AAA AAA Prepay / Collateral Credit Models (Mortgage Loans) AA AA Prepay Cash Default Flow A A Interest Loss Severity Engine Rate and BBB BBB HPA BBB- BBB- Simulations Sub Sub Losses Losses Macro Factors & Assumptions 19 May 5, 2009

MBS Valuation Process  Collateral – Extensive history – Utilize loan level experience  Macro factors – Home prices – Interest rates – Unemployment 20 May 5, 2009

Model  General Characteristics – Transparent – Credit Focus  Prepay model – Willingness • Interest rate – Ability • Current LTV • Lending standards/policies • Federal government initiatives 21 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 22 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’ 23 May 5, 2009

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 Moody's Subprime FRM First Lien 30% 20% 10% 0% 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 Age (months) 24 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 25 May 5, 2009

Challenges/Pitfalls Source: Moody’s March 5, 2009 26 Source: Moody’s Subprime RMBS Loss Projection Update, March 5, 2009 May 5, 2009

Challenges/Pitfalls Source: Moody’s January 22, 2009 27 Source: Moody’s Alt-A RMBS Loss Projection Update, January 22, 2009 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 • 28 May 5, 2009

A Priori Development - Frequency Illustrative Loan Characteristics Amortization Loan Size FICO-LTV Prime Alt-A Subprime Documentation Interest Only Occupancy Loan Purpose Property Type 29 May 5, 2009

A Priori Development - Frequency Source: “Negative equity and foreclosure: Theory and evidence”, Christopher L. Foote, Kristopher Gerardi, Paul S. Willen, 30 Journal of Urban Economics 64 (2008), pp. 234-345 May 5, 2009