The Emperor's New Clothes

National Mortgage News article on Model Validation

We recently wrote an article on Model Validation for National Mortgage News. You can find it here:

August Fannie Mae Prepay Speeds

Annualized one-month prepay speeds on Fannie Mae MBSs seem to support the prepay models high expectations.  The data below is based on the underlying mortgage coupon, not the pass-thru rate.  I also, excluded those tranches that had statistically insignificant volume. 

As you can see, everything above 4.5% is getting hit pretty hard.  The seasoned pools are not quite as bad as the moderately seasoned.  ARM pools (not shown) prepayed at an annualized rate (CPR) of 25%

There is a wide divergence of speeds by state.  The “bubble” states (AZ, CA, FL & NV), interestingly, were all among the highest prepay states.  Puerto Rico was the slowest.

We will be updating this monthly and, hopefully, start to be able to draw conclusions as we gather more data,

Discount Rate Is Often Misused

Every finance student has been exposed to the concept of the time value of money.  They learn how to calculate the net present value (NPV) of even and uneven cash flows and the importance of the discount rate.  This rate is synonymous with your required yield and is often tied to a market rate of a comparable asset plus or minus some risk spread.  This is normally further adjusted to insure that minimum corporate profitability goals are achieved.  Often this rate is referred to as the “hurdle rate”.   What is rarely discussed, however, is how to derive the appropriate discount rate on negative cash flows.

This issue comes up when valuing portfolios of distressed mortgage loans that are expected to throw off significant losses.  It is easy to construct such a portfolio where the NPV of the expected cash flows increases as the hurdle rate goes up.  This is counter-intuitive and does not reflect market reality.

A simple illustration may make my point:

  1. I have a contract to receive $100,000 one year from now.  I want to sell this receivable to you today.  You will pay me $91,000 if you want to earn 10% on your money (the hurdle rate).  If I were to tell you, however, that it is uncertain if you will receive the entire $100,000 a year from now, you will probably conclude that such uncertainty will demand a higher return – say 20%.  Accordingly, you will only pay $83,000 for the receivable.  Alternatively,
  2. I have a contract to pay $100,000 one year from now. I want to sell this payable to you today (i.e. give you cash to take over the liability).  Would you accept $91,000 from me if your hurdle rate is 10%?  If I were to tell you that the $100,000 is uncertain and you may have to pay more than the $100,000 a year from now, would you then accept only $83,000 for the payable?

Needless to say, #2 does not make any sense.  You would not discount the payable to this extent unless you were sure you could reinvest these dollars at 10%.  Not only is this implausible, but why would you want to share this upside with the seller?  You would probably use a risk-free rate such as the 1 month Treasury (0.02%).  If the payable amount is uncertain, and could be higher, you would certainly NOT discount the amount you want from the seller of this negative cash flow.  You would want an amount closer to, or equal to, the payable. 

On negative cash flows, you should not use your hurdle rate, but rather your marginal reinvestment rate, adjusted downwards for increased volatility.

The difference is huge.  The net present value of a constant negative cash flow of $10,000 per month for 15 years is $1.2MM at a 6% discount rate.  At a zero % discount rate it equals $1.8MM.  If $1.8MM reflects par (100), the $1.2 equals 66.  The former negative value (i.e. par) is more reasonable theoretically, and certainly more in line with the way the market looks at negative cash flows.

MSR 3rd Quarter 2011 values

As anticipated, MSR prices, as of September 2011 10Qs, are down once again.

MSA Limits in Basel III
August 23, 2010, 5:00 pm
Filed under: Mortgage Markets, Valuation Tools | Tags: , , , , ,

The proposed capital rules under Basel III would limit capitalized mortgage servicing assets (MSAs) to essentially 10% of Tier 1 capital.  This could adversely impact servicing market values.  Accordingly, I took a quick look at whether or not there may be a problem.  My conclusion is that there may be some dislocations at the bank level, but there is not a substantial systemic risk to servicing values.

There were 7,941 banks and thrifts in the United States as of 3/31/2010.  Of these, 1,137 had capitalized servicing (MSAs) on their books.  67 of these institutions had MSAs that exceeded 10% of Tier 1 capital, the remaining 1,070 were under 10%.  The bad news is that in order to reduce their MSAs to 10%, the 67 institutions would need to reduce their holdings by $24.8B.  This equates to approximately $2.8T of mortgage servicing principal balance at an assumed value of 90 basis points.  The good news is that the remaining 1,137 institutions, that are under 10% concentration, have adequate capital to absorb essentially all of this $2.8T ($2.6T anyway) if so desired.  This assumes that the banks that currently have no servicing wish to remain that way (a good bet for the most part).  It also assumes that non-bank mortgage servicers will not absorb some of this product.  This is probably not the case.

There are several ways an institution can address their overage:

  • Sell part of the portfolio – Only 28 of the 67 “over limit” banks are over by greater than 10% of Tier One capital and may need to sell. Their overage aggregates only $350B of servicing principal balance. 
  • Accelerate amortization and sell more loans servicing-released – It is conceivable that the other 39 institutions will manage their concentrations down through a more accelerated amortization combined with more servicing-released sales.  Additionally, normal prepayments and curtailments will also reduce their exposure materially before the proposed regulations take effect in 2012.  

Implementation of these capital limits, while non-sensical, should not create a large supply/demand imbalance and, therefore, should have little impact on servicing value. 

NB … please let me know if you would like to see the bank level data that went into this analysis.  Also, I would appreciate your thoughts on this subject.

Mortgage Markets – week ending 6/4/10
June 4, 2010, 6:10 pm
Filed under: Mortgage Markets | Tags: , , ,

The 10 year Treasury rate inched back up another 8bps to 3.39%; although the 30year mortgage rate did not follow, remaining essentially flat. The bigger news, however, is that that 10.5% of those that already have bank-owned mortgages (approximately $2.5T) have decided not to make their payments.  As the graph below shows, March 31, 2010 call report data shows that delinquencies continued their inexorable climb.