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:

9/30/2012 MSR Values
December 5, 2012, 4:17 pm
Filed under: Mortgage Servicing Rights, MSRs, Valuation Tools

The third quarter MSR values for several of the larger servicing companies have been published in each of their respective 10Qs.  The results are summarized below:


As you can see, MSR values have continued there inexorable slide, but at a slowing rate. The weighted average value was 109 basis points as of year-end 2009, it dropped to 99bps at year-end 2010, 68 at 12/31/2011, and now it has declined to 61 basis points. The good news is that 61 is only 3 bps lower than it was in June. Maybe we are approaching, or have hit, bottom.

8/15/2012 SIFMA Prepay Speeds

Speeds for the 15th have been posted on our site. They appear to have diminished substantially from their 7/31 highs,

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.

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.

OAS Analysis is not a Valuation Tool
August 11, 2010, 12:44 pm
Filed under: Valuation Tools | Tags: , , , , , , ,

Option-adjusted spread (“OAS”) analysis is not well understood by our industry.  OAS should not be used to generate an assessment of value but, rather, as a very useful output of the valuation process.  It is an important financial tool that adds tremendous insight into the risk dynamics of mortgage related assets, but it does not produce a market or economic value.

The process of developing an OAS is very telling:

  • Generate a large number of randomly generated future interest rate paths;
  • Produce cash flows along each path at a risk-free rate plus a spread;
  • Obtain a simple average of the net present value of these cash flows;

This produces a simulated price.

  • If this simulated price does not equal the market price, choose another spread and rerun;
  • Repeat this process until the simulated price equals the market price

The resultant spread is the OAS.  This OAS is calibrated to market value; not the other way around.

The current usage of OAS analysis as a tool to determine price implies that we know the risk spread that the market demands and, thus, can use this spread to determine price.  This is intellectual hubris.  The spread is predicated on a large number of very complex assumptions and models, few of which are directly observable in the marketplace.  These assumptions include, but are not limited to:

  • Rate volatility (the speed at which future short rates change from their current implied values
  • Rate constraints (high/low)
  • Mean reversion properties
  • Distribution (normal or log normal)
  • Yield curve model (instantaneous forward rate or short rate)
  • Interest rate path generation (single or multi-factor)

Additionally the OAS, while ostensibly a stochastic measure, is heavily influenced by a deterministic prepay model.  While most analysts would test their OAS with sensitivities based on 90% or 110% of these prepay models, this simply “measures the sensitivity of OAS to consistent misestimation of the prepayments … not to random fluctuations around the model’s predictions.”[1]

And, even if these assumptions were observable and defensible, the option adjusted value is still meaningless from a valuation perspective.  It is an average of hundreds of different interest rate paths.  Possibly one of them is the correct path (i.e. what actually occurs), but there is no assurance that this is true, nor is there even a meaningful probability that this path is the “average” path that the OAS concludes.  “It is extremely unlikely that a security will actually earn its calculated OAS.”[2]

If you look at the distribution of values that an OAS analysis produces, you will see my point.  A greatly simplified example is shown below. 

This simplified example shows only five possible outcomes: a yield on the investments of: 0%, 7.5, 15, 22.5 or 30%.  The model generates a frequency distribution of these returns as indicated from a low of 3% to a high of 40% (naturally they sum to 100%).  As is typical with mortgage related investments, the distribution is not normal; it is negatively convex (skewed to the left).  Because an OAS value is a simple average of values over the entire distribution, the OAS value in this case would result in an average return of 15% (the “mean”).  Not only is this value far from a certain outcome, but it is not even the most probable outcome.  The most probable outcome (the “mode”) returns only 7.5%.

I would not pay a price that equates to a yield of 15% when the most probable outcome is a yield of 7.5%.  Additionally, I would look closely at the dispersion of the expected returns emanating from these hundreds of paths.  If the deviation around the mode is small, I may be willing to pay the price related to the modal price (never the mean price).  If the dispersion, however, is large, I would discount the price substantially.

OAS provides very useful information about the expected cost arising from the mortgagors’ ability to prepay at will.  It does not, however, measure credit risk nor does it provide the answer to the question of “what is the value of this asset”?

OAS has become a fad; one number that ostensibly summarizes the entire range of financial dynamic of the mortgage asset.  Yet this is not what the architects of OAS intended.  They never “intended the OAS to be viewed as a ‘yield takeout’ over Treasuries.  Because it’s the result of an averaging process.”[3] Financial analysts love to talk about OAS while disparaging scenario and other analyses.    Yet, from a market value perspective, OAS is a very elegant and expensive way of being wrong.


N.B.  Blogs do not allow for a lengthy discussion of any subject.  I will be publishing a more comprehensive discussion of this topic in Mortgage Banking Magazine and will advise those who are interested as to its publication date.

My next blog will address level 1 (under FAS 157) alternatives to valuing mortgage related assets.  This will not be available until the first week of September.  For the remainder of this month I will be focused on producing an article for Mortgage Banking Magazine (October 2010 edition) on identifying paradigm shifts in our industry before they wreak their havoc on us.

[1] Robert W. Kopprasch, Financial Analysis Journal, May-June 1994; page 45

[2] Robert W. Kopprasch, Financial Analysis Journal, May-June 1994; page 43

[3] Robert W. Kopprasch, Financial Analysis Journal, May-June 1994; page 43