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Valuation Commentary - Oct. '07
Credit OAS: Next Steps and Challenges
by Alex Levin
AD&Co.’s implementation of Credit OAS has progressed well beyond its first steps reported in the April and May Pipeline articles. We are now able to value a cohort of loans efficiently. This capability is useful for whole loan portfolio management and the assessment of a loan guarantee business (like that of the GSEs). We can also value CMOs and ABS (as well as ABX indexes) using loan-level simulations linked to INTEX cash flow generators. This article reviews the next steps and challenges for the completion of our goals.
Credit OAS Basics
Credit OAS is a valuation method that employs coupled simulations of interest rates and home prices. Along each random path, prepayments, defaults, delinquency and severity rates are generated with the LoanDynamics™ Model (LDM). We can produce the value of the actual instruments (with all desired Greeks) or the value of losses only.
Naturally, the market factors, interest rates and home prices, should follow risk-neutral dynamics observed in other markets. There is no need to discuss a risk-neutralization of interest rates – this is an established process. However, other aspects of risk-neutral valuation of credit-sensitive MBS are not well established.
Home Prices and Greeks
With regard to home prices, the US real estate derivative market is being developed. For example, last month, ICAP (http://www.icap.com) started trading derivatives using Radar Logic’s daily indices. Last year, Chicago Mercantile Exchange (CME) established a similar market using S&P/Case-Shiller’s monthly indices. These markets, if large in size, can deliver instruments that hedge against credit losses – to the extent explained by home prices. In addition, practically all dealers trading ABS and ABX provide their own forecasts of home prices. Those should be used with caution because (A) for any market factor, there is generally a difference between risk-neutral and physical expectations, and (B) we have already seen predictions that looked outrageous from day 1 and never materialized. For instance, many analysts talk about the real estate bubble and expect home prices to decline materially in the next few years; these views are hardly in line with the OFHEO historical record dating back to 1975.
