Quantifying Risk in Mortgage-Backed Securities
THE OPPOSITE SIDE OF RISK MITIGATION is risk exploitation, and there’s currently an opportunity on the asset side for insurers
and other financial institutions that exploit risk. Asset impairments flow
through and affect surplus levels, leading to potential business-funding
issues. These losses can also pressure risk-based capital levels. In some
circumstances, they can lead to forced decisions such as bankruptcy,
mergers, or sales of business lines. A better understanding of the risk
embedded on the asset side of the balance sheet should engender confidence to capitalize on the opportunities presented to many institutions. With appropriate analysis and understanding, firms can exploit
the current situation to enhance value to their stakeholders.
The current economic crisis had its
origin in the residential mortgage market,
which has certainly suffered severe stress
in the past couple of years. What started
as a subprime mortgage problem quickly
evolved into a broad mortgage crisis with
waves of losses in Alt-A mortgages (a
cousin of the subprime) and even prime
loans. This real-world stress test has inflicted severe pain on many institutions
holding assets tied to these markets, including general insurers and particularly
life insurance companies. These assets include mortgage-backed securities (MBS),
asset-backed securities (ABS), and collat-eralized debt obligations (CDO). Rising
defaults and declining house prices have
FIGURE 1
led to downgrades by the rating agencies
and illiquidity. In such an environment,
many have questioned the severely impaired market values of these securities as reasonable accounting values
and as measures of intrinsic value.
Actuaries with strong expertise
in modeling mortgage credit risk
are well-positioned to assist both
management and boards of directors in making sense out of current
market conditions. The key is deriving the discounted cash flows from a
given security based on an independent
analysis of the underlying loan-level collateral pool, coupled with a cash-flow
early years, agency issuers such as Fannie
Mae, Freddie Mac, and Ginnie Mae dominated. However, with the emergence of
new loan types and dramatically lower
interest rates during late 2001 and 2002,
non-agency issuers quickly began to take
market share, rising from 15 percent of
the issuance market in 1995 to 55 percent
in 2005. When home prices began falling
in 2007 and 2008, these players ran into
financial difficulties and rapidly began to
lose market share. The deterioration in
the secondary market for non-agency securities exacerbated those market-share
losses in late 2008 and 2009.
Home prices, as measured by the
Case-Shiller index, peaked in the middle
of 2006. Once they began to decline, options for current and potential homeowners were materially restricted. Secondary
markets for MBS over the past year have
frozen, with brokers and dealers unwilling
to provide liquidity or providing liquidity
only with punishing bid-ask spreads. This
lack of liquidity and declining home prices
are leading to a vicious cycle (illustrated in
Figure 1). As home prices fall, the potential losses on MBS rise, resulting in falling
prices. The lower prices force institutions
holding these assets to recognize losses
and tighten standards for making new
loans. Current and potential homeowners are left with fewer financing options,
leading not only to forced sales but also to
a lack of new buyers. This, in turn, causes
home prices to fall further.
The erosion of both liquidity and
value can be seen in many parts of the
market. For example, the interest-rate spread of conventional mortgage loans over Treasuries, which
Potential
had been in the range of 140 to 160
Loses on
basis points from 2004 through the
MBS Rise
middle of 2006, increased to 280 basis
points by late 2008. Another example is
the value of the Markit ABX.HE index of
AAA-rated subprime MBS from the second half of 2007, which further declined
engine that overlays the security capital
structure. This produces the cash flows
for the security in question and allows
the actuary to quantify the risk associated
with uncertain collateral performance.
A Quick Primer
on the MBS Market
The MBS market expanded rapidly from
the 1990s into the current decade with
gross issuance increasing from $318 bil-
lion in 1995 to nearly $2.2 trillion by 2005.
It was only with the emergence of a more
difficult economic environment in recent
years that issuance began to decline. In the
Home Buyers
Have Fewer
Financing
Options
Home
Prices
Fall
Institutions
Tighten Lending
Standards
MBS
Prices
Fall
