Every so often, we all need a little tune-up. If your back is aching, a visit to the chiropractor for an adjustment may be in order. If the timing on your car is misfiring, your neighborhood mechanic has the tools and diagnostics to get the engine purring again.

It is the same case for empirical models that are based on historical data. Every so often, current events deviate sharply from the past and the model needs to be adjusted to more accurately capture recent collateral performance. Adjustments can also be made to help the user assess the model’s sensitivity to various parameters or to reflect an opinion on the impact that various loan types and issuers will have on collateral performance. Link to this article

Since we have discussed various way to tune our prepayment models over the past couple months, we believe it is a good time to step back and do a review of all of the tuning parameters that are available within AD&Co’s suite of prepayment models. 

We make tunings available to clients to give the models as much flexibility as possible, as well as to allow adjustments to the model when market conditions change suddenly.  Given the turmoil seen through much of 2007, the tuning parameters have been a useful tool for clients to adjust the forecasts of prepayments to better reflect what they have been seeing on their own portfolio.  Link to this article

This issue of The Pipeline is dedicated to how various tuning parameters embedded in AD&Co.’s prepayment, LoanDynamics™, and valuation models can be used. The articles written by Dan Szakallas and Anne Ching describe how using this important tool can improve the performance of empirical models. This was the initial purpose of exposing the tuning knobs, or dials, to users.

In this article, I will discuss a different use of the tunings that relates to MBS pricing. At first, this may seem to be a purely ad-hoc exercise. In reality, this simple step is marked by full quantitative rigor; it reflects how the MBS risk is priced by the market and how this way of pricing, often termed “risk-neutral,” should be reflected by tuning a prepayment model. Link to this article

The LoanDynamics™ Model (LDM) is an economic model of prepayment, delinquency, default, and loss which is calibrated to historical data. As such, it provides critical information about the relative effects that different variables have on borrower behavior. However, one of the most valuable features of LDM is its flexibility, since it allows users to scale major parameters and inputs within the model.

AD&Co. believes that users should have the ability to perform sensitivity analyses, and to express a view about how a particular collateral type or issuer should perform. Similarly, there are situations when the current market deviates significantly from historical performance, and thus behavioral models require adjustments to reflect market dislocations. Link to this article