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The sum of Expected Loss and Risk Premium is also known to be equal to the Expected Loss under risk-neutral dynamics of the random market factors. Therefore, the same formula can be re-written as:
Price (perfect MBS) – Price (actual MBS) =
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In the current market, the real-world expected loss may be just a small piece of the puzzle. According to our February 2008 Pipeline article, the liquidity spread was found to be 200-400 bps when an ABS structure was analyzed in September of 2007; liquidity has deteriorated since then.
Myth 2: The Price of credit risk should be close to the expected losses
Let us not to forget that ABS, CDS and other structured instruments are financial derivatives. The underlying is loan losses. Let us think for a moment how a mortgage insurer (MI) or a GSE charges for the loan loss protection. They surely must charge more than the real-world losses because they protect against worst-case scenarios. AD&Co was asked to work on a project that involved this task; we found that the risk premium can be of the order of 40% to 70% of expected losses. This will define the risk-neutral loss assumptions, from the MI and the GSE stand-point.
However, tranches absorb losses in a highly non-linear fashion. If we expect cumulative losses of collateral to be 10%, our bond may be well and alive. But, if we increase the losses to 14% or 17%, the bond may vanish. Hence, the market may seriously discount tranches that otherwise experience small losses under seemingly “realistic” market assumptions. If this logic wasn’t in place, the investor could have sold bonds and bought protection on the underlying loans.
Myth 3: HPI derivatives reflect market expectation of future home prices
Certainly not more than the forward curve points to rate expectations, forward prices – price expectations, etc. We recently received a note from OFHEO announcing the release of a new paper, A. Leventis, Real Estate Futures Prices as Predictors of Price Trends. The author states, "For many commodities, futures markets provide informative, unbiased measures of anticipated prices for the underlying product.
