These characteristics are used to develop
the probability of default for three illustrative loans. In Figure 3, the closer to the
center of the graph, the lower the risk factor. Typical characteristics of Alt-A loans
are low or no documentation and high
loan size, while subprime loans generally
have low consumer credit scores.
Once the initial a priori loss is derived, utilizing the loan-level collateral
underwriting factors referred to above,
an adjustment is made that reflects economic conditions affecting the losses.
Home-price trends tend to have the
most substantial impact.
With a default, the severity is derived
using property-price changes, costs during foreclosure, accrued interest, and
other factors. The a priori loss estimate
is the probability of default times its severity. The BF method can be used to
calculate the remaining loss rate by using the a priori loss rate, the loss curve,
and losses and persistency to date.
In recent months, independent financial institutions and different levels of
the government have been introducing
innovative programs to assist homeowners who are unable to meet their monthly
payments. Adjustments can be incorporated to integrate the impact of these and
other programs on overall loss estimates.
Prepayment and credit-loss values chosen from the approaches described above
are needed to project future cash flows.
Many of these securities have multiple
tranches that have different payment triggers for scheduled principal, interest, and
losses. A cash-flow model delineates overall collateral performance from original
borrowers to the different security holders, based on deal triggers. Future cash
flows to the investor are then discounted
to get a present value for the security.
Getting to the True Value
All of the above describes a general
method for calculating the intrinsic
value of a security. Risk quantification
begins by understanding the range of
outcomes that can evolve from the process. In better economic times, it was
difficult to envision the current strained
scenario as part of what could really
happen. Many believed that a new paradigm was in play, where credit losses
would not be a concern and economic
growth would continue as the world began to integrate. However, this is exactly
the reason for scenario analysis and risk
quantification—it provides the company
with a better understanding of the potential value of the security beyond financial reporting purposes to strategic
risk management purposes.
NEAL DIHORA is a financial consultant
and KYLE MROTEK is a principal and
consulting actuary with Milliman in
Brookfield, Wis. MICHAEL SCHMITZ
is the principal and consulting actuary
who manages Milliman’s credit risk
practice in Brookfield.
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