
	February 28, 2005 Welcome to The Pipeline, Andrew Davidson & Co., Inc.'s monthly newsletter. Created as a "pipeline" of relevant and useful information for participants in the fixed income industry, we address recent trends, changes and advances that our consultants, developers and sales force have extensively studied. We value your input and urge you to contact us with questions, comments or article suggestions. Enjoy!



	Consulting Corner Valuation Commentary Model Performance Review AD&Co. Update

Consulting Corner

The Competing Risks of Mortgage Prepayment and Default

By Kyle G. Lundstedt, Ph.D.

The Increasing Relevance of Credit Risk to Mortgage Investors
There is an enormous amount of credit risk in the mortgage sector. Government statistics show that over $3.8 trillion in single-family residential (SFR) mortgages were originated in 2003. Even a very small percentage credit loss on such an enormous asset class would have serious repercussions for the U.S. economy.

For many years, however, credit risk has been of little concern to investors in mortgage securities. Historically, the housing government-sponsored enterprises (GSEs) - Fannie Mae, Freddie Mac, and Ginnie Mae -have provided significant if not total protection from credit risk for well over half of the mortgages originated in the U.S. each year. The remaining credit risk traditionally was held in portfolio as whole loans by financial institutions such as banks and thrifts. Nonetheless, in the last ten years, mortgage investors have seen the emergence of a significant secondary market for "non-agency" mortgage-backed securities (MBS), mortgage-related asset-backed securities (ABS), and the collateralized mortgage obligations (CMOs) derived from there. As a result, fixed income investors now must concern themselves with measuring and understanding credit risk, in addition to the traditional market and prepayment risks for mortgages.

In this article, we describe some commonly used tools for measuring credit risk. We discuss the pros and cons of these tools and then describe a methodology called "competing risks" models. We discuss how prepayment and default constitute competing risks in the context of mortgages and give some examples of why mortgage investors might consider this methodology for use in evaluating "non-agency" MBS and ABS. Read more...

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Valuation Commentary

A New Member of AD&Co: The Two-factor Gaussian Term Structure, Part 2

By Alex Levin

Last month we introduced a two-factor Gaussian model, the latest addition to AD&Co's suite of term structures. I pledged to touch on an intriguing and practically important question: what financial instruments are valued differently when moving from a single-factor view to the two-factor view? Since a correctly calibrated two-factor model simulates the rate collection in a much more realistic and accurate fashion than any single-factor model, it seems at first glance that two- or more-factor modeling may reveal values and risks way beyond the primitive picture drawn by any single-factor model. Read more...

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Model Performance Review

Big Drops in Prepayments

By Dan Szakallas

Prepayments took a nose dive in January, as many factors conspired to cause drops larger than were expected. FNMA 30-year prepayments for 5.5 to 6.5 coupons dropped about 20 % from December. This was definitely more than the normal seasonal decrease. A small increase in mortgage rates seemed to also contribute to these big drops. All collateral types across all coupons showed decreases from the previous month. Below we show Actual pool CPR speeds of selected coupon buckets, along with corresponding model forecasts. Read more...

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AD&Co. Update

Growing Team, Growing Conference & More...

By Ilda Pozhegu

AD&Co.is happy to announce the great news that we have hired veteran fixed income specialists Kyle Lundstedt and John Ferrante to lead the development of credit models for residential mortgages. Check out this month's Consulting Corner, where we put Kyle right to work in sharing his valuable insight into Credit Risks.

Kyle Lundstedt has significant expertise in developing customized risk models for large financial institutions. As Managing Director and co-founder of VaRisk, he led his research firm in building customized valuation and risk management tools. He was Vice President of Analytics at LoanPerformance, a vendor of mortgage analytics, and prior to that worked on the professional staff of the House Banking Committee. Kyle earned a Ph.D. in Business Administration (Finance) from U.C. Berkeley and a B.A. in Economics and Political Science from Yale University. His published work has appeared in both academic journals and applied publications, and he has spoken at numerous industry events.

John Ferrante brings his extensive programming background to Andrew Davidson & Co., Inc. Co-founding the aforementioned VaRisk with Kyle, John was also Senior Software Engineer for the research firm. He held a similar position at Loan Performance where as Senior Software Engineer he built interest rate generators, prepayment models and data analysis tools for large lending institutions. Before that John worked at Bank of America as an Applications Software Engineer and Vice President in the interest rate risk group. He holds a BA in Math and an MA in Statistics, both from UC Berkeley.

We are very excited to add Kyle and John to our team and hope that with their help and experiences, we may provide our clients with further tools to analyze and understand complex mortgage-backed securities and to evaluate the credit risk of mortgage loan portfolios.

Manifest Destiny

Spring brings the expectation of assorted pleasantries; a blooming bud, a chirping finch, a tree come to life, a spirited panel discussion on Prepayment Model developments. Well, we can't promise you the first three, but the last gift of spring is already in motion. Our roots remain planted in New York City, but this year, the AD&Co. Annual Conference is branching out to a coast near you!

Save the Date for the highly anticipated AD&Co. Annual Conference:

New York City – Thursday, June 2, 2005 – Tribeca Rooftop

San Francisco – Tuesday, June 7, 2005 – W Hotel San Francisco

Invitations, Agenda and Details are coming soon.

Validation Procedure

A note from our developers to all clients regarding our validation process is available by clicking here.

Datafile Information

Beginning with February data files, we now no longer override the mortgage current coupon indices for 5 and 7 year balloons generated by Bloomberg. From May 2003 through January 2005, AD&Co recalculated these indices to better reflect actual balloon yields. An analysis of the spread between the balloon yields to the Fannie 15 year yields indicates that this spread has returned to historical norms. Because of this, we believe the Bloomberg current coupons are reflective of yields in the market. As a result...

**** QRM users no longer should be adding a spread to the weighted 2 and 10 year treasury rates for balloons.****

For information on spreads, please visit our website by clicking on the link below:
http://www.ad-co.com/support/user/cc_methodology.htm

As always, feel free to contact us with questions at 212-274-9075.

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