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Valuation Commentary - April 08
Six Myths of Credit Valuation
by Alex Levin
In recent months, AD&Co has been asked to help firms understand and manage risk relating to credit-sensitive MBS, both in the US and abroad. While it is not always easy to explain the market’s rationale in times of panic or stagnation, we warn investors not to be misguided by some common myths that have surfaced.
Myth 1: Market prices of MBS and ABS reflect expected losses
“The market prices our portfolio to x% of losses. What does the LDM predict?” We have been approached with this exact question and it suggests, in itself, that the direct loss levels obtained from the LoanDynamics™ Model (LDM) can be employed to rationalize MBS prices.
First, the LDM gives us only projected losses for a market scenario given interest rates and home prices. The market certainly considers volatility and scenarios that are worse-than-average. Second, even the averaged outcome will be insufficient if we don’t consider the price of risk. In scientific terms, the interest rates and home prices have to follow “risk-neutral dynamics.” Third, today’s non-agency MBS market is not liquid and the liquidity premium is a big part of valuation.
In symbolic terms,
Price (perfect MBS) – Price (actual MBS) =
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