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
RAE_half_pg_ad:x 1/29/2009 8:45AM Page1
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-
Actuarial Science is
not Rocket Science.
IT’S MORE COMPLICATED.
Actuaries might not send astronauts to the moon. But
like rocket scientists, they are in the business of
making risky endeavors more predictable.
Actuarial science involves researching variables which
are constantly changing – financial risk, economic
indicators, demographics, catastrophic events.
Research that makes a difference doesn’t happen by
chance. It’s the product of hard work, partnerships with key groups and a
ready pool of bright, creative minds.
Your contribution to The Actuarial Foundation supports independent research
that tackles today’s most relevant topics:
• Can Social Security afford the Baby Boomer retirement wave?
• What’s the most appropriate way to fund public pension plans?
• Do health care co-payments and deductibles improve preventive care and
affect long-run health insurance claims?
• What is the financial impact of natural disasters?
By supporting the groundwork for textbooks, symposia and publications, The
Actuarial Foundation helps actuaries build stronger relationships with
the academic community and reach a broader audience.
Supporting Actuaries, Present and Future
You Can Make a Difference
Your donation to The Actuarial Foundation helps fund scholarships, awards
and prizes recognizing the exemplary work of students and professionals in
advancing actuarial science. Scholarships for deserving students range from
$1,000 to $7,500. The Foundation recognizes actuaries’ accomplishments for
research that furthers knowledge about actuarial science, employee benefits,
enterprise risk management and promotes public awareness of financial risk
with awards from $1,000 to $5,000.
Because of the generosity of our sponsoring actuarial organizations, 100
percent of your donation goes directly to support programs and is 100
percent tax deductible.
Make a donation, learn more about Foundation-funded research or award
opportunities by visiting The Foundation’s Web site,
475 N. Martingale Road, Suite 600 • Schaumburg, IL 60173-2226
phone: 847.706.3535 • web: actuarialfoundation.org