Actuarial Approach to Valuing Mortgage Backed Securities, presented at the 2009 East Asian Actuarial Conference in Seoul Korea

1. Mortgage-Backed Securities:An Actuarial Approach to Cash Flow ValuationNeal Dihora, ASA, MAAA, CFA Kyle Mrotek, FCAS, MAAA 15th East Asian Actuarial Conference Seoul, Korea 13 October 2009

2. Agenda MBS Background Benefits of MBS Valuation Approach to MBS Valuation Closing

3. U.S. MBS Issuance A mortgage-backed security is a debt obligation that transfers cash flows from borrowers who have purchased homes to investors looking for a higher yield than government bonds Agency securities are sold and guaranteed by the U.S. government Fannie Mae Freddie Mac Ginnie Mae Non-agency securities are not backed by any financial institution Higher risk, higher yield potential Agency securities have regained their popularity

4. Gross Issuance

5. Non-Agency by Type

7. Improve transparency

8. Keep up with compliance

10. Mortgage Models Structural models Focus on underlying dynamics of the mortgage and of trigger events (prepayments and defaults). Do not consider collateral performance to date Borrowers are assumed to exercise the option which is in their best interest Reduced-form models pattern exogenous trigger events with hazard rates or jump processes Actuarial models Focus on forecasting mortgage borrowers’ failure to make timely payments (collateral analysis) Future collateral credit loss can be considered as a function of current loss Cumulative collateral credit loss can be obtained from many sources, for example, consider the MBS, HEAT 2007-2 2A1:

13. Amount and timing

14. ‘Loss’ is failure to pay timely P&I

15. Methods

16. ‘Paid’ Loss Development Factor (LDF)

17. ‘Incurred’ LDF

18. ‘Paid’ B-F method

19. ‘Incurred’ B-F

21. Normalize loss to exposure -> loss rate

22. Ultimate loss = paid loss x cumulative paid LDF

23. Incurred LDF

24. Inventory of delinquent loans is used to estimate proxy for case reserves – delinquency status found to be predictive for future performance

25. Incurred loss equals cumulative paid loss plus proxy for case reserves

26. Consistent with reserving for mortgage guaranty insurance

27. Roll rate model = Frequency/Severity method

28. Frequency = Pr (default | status of delinquency)

29. Severity (% of loan that is not recoverable)

31. Challenges/Pitfalls Source: Moody’s Subprime RMBS Loss Projection Update, March 5, 2009

34. Requires loss to date, a priori loss, and a loss development curve

35. Future loss indications tend to be heavily weighted toward the a priori loss estimate for recent vintages

38. Economic factors

45. Home price changes

46. Costs of foreclosure (realtor, legal, upkeep)

47. Accrued interest

48. Stressed sale

50. Paid loss to date

51. Paid LDFs

52. A priori loss

53. Estimates future paid loss

54. Incurred B-F

55. Paid loss to date plus proxy for case reserves = Incurred loss

56. ‘Incurred’ LDFs

57. A priori loss

59. Risk Quantification

61. Credit risk exists

62. Activities positioned to analyze credit risk

63. Large MBS holders include banks, insurance companies, asset managers