 |
 |
Risk-Neutral LDM
Although ABS investors have many reasons to fear an adverse home price development, they can hedge using available and growing real estate derivative markets. The other component of credit risk is the risk that the model (such as the LDM) understates losses. AD&Co.’s LDM has many tuning dials that can accelerate or decelerate inter-state transitions and loss severity. They can be used for both tuning the model to better match historical experience (physical tuning) and to compensate for the price of model risk (risk-neutral tunings). The latter is reminiscent of our work on risk-neutrality in prepayment modeling. Even with constant interest rates, the prepayment process can be uncertain and a model can be biased. Similarly, losses are somewhat uncertain even in the complete absence of market volatility.
The most efficient and transparent tunings in the LDM are the FICO tuning and the original LTV tuning. Similar effects can be obtained using the “C to D” tuning (Current to Delinquent, i.e. the delinquency process) and “S to T” (Severely Delinquent to Terminated) loss severity tuning. The FICO tuning alters borrower’s credit artificially, hence, making him/her more or less likely to become delinquent. The LTV tuning influences the default option’s moneyness, hence, the default rate and loss severity.
AD&Co. is not currently in a position to appropriately separate HPI risk from the LDM model risk. This opportunity itself is a function of the real estate derivative market. However, we are up to the task of bringing each type of risk into the valuation process in a rigorous manner.
