Consulting Corner

Back in the Forefront
by Andrew Davidson

The mortgage market has been the leader in securitization trends for many years. The mortgage-backed security, the collateralized mortgage obligation and the senior subordinate structure are innovations derived from the mortgage market. The mortgage market has also been the source of numerous other innovations in credit enhancement and structuring.

Over the past few years, the US mortgage market has trailed other markets including European mortgage markets. The recent growth of credit default swaps (CDS) and other synthetic transactions such as synthetic Collateralized Debt Obligations (CDO) in the US mortgage market, and particularly in the home equity (or sub-prime sector) will bring the mortgage market back into the forefront of innovation.

Due to the complexity of the mortgage market, mortgage research was in the forefront of analytical development. Effective duration, option adjusted spread and loss curves were all innovations that began in the mortgage market. However, in recent years the markets with synthetic trading of credit have developed more sophisticated credit risk measurement tools than the mortgage market. More analytical credit tools have been seeping into the mortgage market through the Basel II accord, which would bring the techniques used in other markets to the mortgage market.

With the development of the CDS market, the synthetic CDO market and the growing acceptance of Basel II approach to capital requirements, the seepage will become a flood. In a few years, all serious players in mortgage credit will be active users of the techniques of other credit products, including distribution assumptions, attachment points, correlations and copulas.

As a simple example of these techniques, I show the impact of changing the correlation between assets on the pricing of an extremely simplified mortgage transaction.

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