Contingencies Online - July/August 2009

parties, such as members of boards of directors, necessitates an appreciation for the full range of potential scenarios. For example, a chief risk officer at a large commercial bank may use value-at-risk to assess the impact of “stress” scenarios on the bank’s capital levels. One might be tempted to use a normal distribution of outcomes to quantify the risk. However, this may generate a false sense of security. For example, if the daily price changes on the Dow Jones industrial average followed a normal distribution, they would have moved more than 4. 5 percent only six times from 1916 to 2003. In fact, this occurred 366 times. This simple example underscores the need

managing Risk in for more sophisticated measurements the current Environment of the range of outcomes for mortgage-Standard accounting measures use credit losses, which like stock market point estimates for valuing mortgage returns don’t follow normal returns. securities on quarterly and annual state- Figure 2 (see Page 86) summarizes the ments. However, risk quantification for general process in valuing MBS. Loan-both external and interested internal level collateral data and economic factors

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by nearly 65 percent from January 2008 to March 2009. The Federal Reserve’s survey on bank lending practices (conducted quarterly among senior loan officers) shows that lending standards have tightened considerably. During 2004 and 2005, the percentage of loan officers constricting their lending standards for residential mortgage loans was negative, indicating that they were loosening standards. By contrast, during the second half of 2008 and early 2009, this survey showed that more than 50 percent of officers were tightening standards. Combined, these factors are causing a dramatic decline in the availability of credit for individuals and corporations.

will drive inputs such as credit losses and prepayments. These collateral assumptions are used with a cash-flow model to push the relevant cash flows ( interest, principal, prepayments, and losses) through the security capital structure. The output is then discounted to attain a net present value.

The willingness and ability of borrowers will drive prepayments. The most important factor in a willingness to prepay is the difference between the original loan rate and the prevailing available rate. A larger differential generally causes higher numbers of prepayments through refinancing. However, current tight lending standards and declining home values are dampening this impact. Other factors that drive borrower willingness to prepay include loan type (fixed or adjustable rate) and the age of the loan. The ability of borrowers to prepay can be influenced by the equity in their properties, their consumer credit scores, their employment situa-

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