Valuation Commentary

How to Validate an Interest Rate Model
by Alex Levin

Part III: Validation of option values

With the last several articles having been written about prOAS, I got derailed from this model validation sequel. It is time to resume the efforts and bring forth perhaps the most intriguing subject: calibration of volatility to rate options. Indeed, MBS are short of a prepayment option, and everyone knows that the options are driven by volatility. Perhaps the most stunning discovery (at least, from a practitioner's standpoint) made by Black and Scholes is that the price of an option and volatility are two sides of one coin - nothing else is uncertain: stock's price, strike and discount factor are all undisputed. Read more...

Model Performance Review

Prepayment Performance
by Dan Szakallas

Prepayments experienced an increase in August after falling steadily for the past 3 months. The increases were very moderate, none greater than 10% for conventionals. FNMA 30-yr 5.5's rose 8%, while their 15-yr counterparts rose just 4%. GNMA's actually showed greater increases than the conventionals, as 30-yr 5.5's rose by 17% from July, and 15-yr 5.5's increased by 12%. Actual pool CPR speeds of selected coupon buckets, along with corresponding model forecasts, can be seen Read more...

AD&Co. Update

What is ALT- A… Anyway?

The definition of alt-A collateral has become a moving target. This has led to wide variability in prepayment speeds among pools designated as alt-A collateral because the underwriting guidelines and credit quality of these pools varies dramatically. AD&Co recommends that clients that use the MBS Prepayment Model, utilize the appropriate tenor of either the FNMA or FHLMC prepay model instead of the alt-A model until further notice.

The traditional definition of an alt-A borrower is that they meet Fannie Mae and Freddie Mac standards for credit score, but do not meet the standard agency guidelines for documentation requirements, property type, debt ratio or loan-to-value ratio. These borrowers are required to pay a premium for these transgressions. The traditional alt-A borrower was self-employed and because they typically lacked records like payroll stubs and W-2 forms, were unable to refi as readily as their conforming counterpart. Historically, this led prepays on alt-A pools to be as much as 50% slower than agency collateral, especially during the initial term of the loan.

However, a lack of standardization as to the definition of alt-A among mortgage lenders and the prevalence of the GSEs in the alt-A sector have blurred the line of demarcation between alt-A and prime collateral. Further, many lenders now classify conforming loans with slightly higher note rates than prime-quality loans as alt-A and include them in alt-A pools simply because there is no restriction against this practice. The "new" version of alt-A pools now includes whatever lenders or issuers of alt-a MBS choose to include.

If you have any questions, please do not hesitate to contact Rob Landauer at 212-274-9075 or rob@ad-co.com.