Publication DateNovember 2010
Center researchers develop a loan-level residential mortgage-backed security pricing model that can be used to design hedging strategies for mortgage portfolio interest rate risk and price the cost of guaranteeing the securities’ default risk. The model is particularly useful for managing low-to-moderate income (LMI) mortgages and may help the federal government determine how best to serve the needs of these borrowers.
This paper develops an industry-comparable loan-level residential mortgage-backed security pricing model. It can be used to design hedging strategies for mortgage portfolio’s interest rate risk and price the cost of guaranteeing RMBS default risk.
The loan-level pricing model is designed to address most of the problems with the Government-Sponsored Enterprises’ (GSEs) current risk management models that were outlined in the Federal Housing and Finance Administration‘s 2009 report to Congress.
The loan-level pricing model in this paper is able to automatically translate into RMBS prices the slight monthly changes in individual borrowers’ prepayment and default risks due to borrower and loan characteristics, macroeconomic conditions, house price changes and term structure movements.
The loan-level model is especially useful for managing low-to-moderate income (LMI) mortgages, which are highly leveraged assets. Applying the loan-level pricing model to the Community Advantage Program (CAP) dataset yields the result that most (i.e. 65% of the purchased CAP loans) of the Community Reinvestment Act (CRA) mortgages in CAP have been profit-making (i.e. positive Option-Adjusted Spreads OAS) for the secondary market, given the market prices Fannie Mae paid. Moreover, the results suggest that the conventional indicators, such as race, income, credit score and loan-to-value at origination,
are not reliable in determinants of the mortgage yield. Therefore, avoiding and discriminating against LMI mortgage pools is not rational.
The identification of responsible LMI borrowers or pools and adequate risk based pricing require that the loan-level pricing model be run on each mortgage portfolio. Finally, the loan-level pricing model can help to address one challenge in the overhaul of mortgage finance system pointed out by Geithner, namely pricing the cost of a government guarantee of RMBS default risk. In particular, the expected cost for guaranteeing the default risk of a loan can be calculated as the difference in the OAS between 100% recovery and recovery at the current house price.
In short, the loan-level pricing model developed may help the federal government better meet the financial needs of responsible LMI borrowers, while maintaining the sustainability and soundness of the GSEs.