# securitization 301

Post on 12-Jan-2016

49 views

Embed Size (px)

DESCRIPTION

Securitization 301. Dynamic Structuring & Analysis. R&R Consulting. US Capital Markets, 1970-1980s. market risk. Securitization ( la 101 ). Corporate Finance. Derivatives. basis risk. credit risk. Securitization?. liquidity / credit risk. cash. synthetics. - PowerPoint PPT PresentationTRANSCRIPT

Securitization 301Dynamic Structuring & AnalysisR&R Consulting

US Capital Markets, 1970-1980s Securitization ( la 101 )DerivativesCorporate Financemarket riskliquidity / credit riskbasis riskoperational riskcashsyntheticscredit riskSecuritization?

Securitization 101Benchmark Pool (an adaptation of the corporate finance method)

Back-of-the-Envelope (liquidation) Analysis (securitization)Credit risk: value is a function of CE and expected lossesPrepayment risk: to the extent it reduces CECounterparty risk: covers everything else

US Capital Markets, 1990s Securitization ( la 101 or 201)DerivativesCorporate Financemarket riskliquidity / credit riskbasis riskoperational riskcashsyntheticsRated, repackagedmarket riskcredit risk

Securitization 201Scenario-Driven Cash Flow Analysis (securitization)Credit risk: value is a function of CE and loss volatility; prepayment risk embedded in the CF modelCounterparty risk: covers everything elseMonte Carlo Cash Flow Analysis (securitization)

US Capital Markets Now Securitization (MC simulation)DerivativesCorporate Financebasis riskoperational riskcashsyntheticsLiquidity/credit riskmarket risk

Securitization 301Monte Carlo Cash Flow Analysis (securitization)Credit risk: value is a function of CE and loss volatility; prepayment risk embedded in the CF modelServicer risk: has operational and credit dimensionsLiquidity risk: was always there but is more highlightedMarket risk: also highlighted for both accounting & portfolio management reasonsBasis risk: may be part of the cash flow analysisCounterparty risk: do ratings really do the job?

Option-Theoretic Valuation Framework Market risk: price is the goal. Fair value is a structural analysis; prices are a random walkCredit risk: value is approximated through a Merton default model; for credit portfolios, via a Gaussian copulaServicer risk: value is approximated through a Merton default modelLiquidity risk: addressed in a market senseCounterparty risk: not quite on the radar screen.

The Drivers of Dynamic Analysis Drivers of Change

Economic efficienciesLabor market pressuresIncreased regulationMarket Effects of Change

Commoditization of RiskCompetition of ideasMarket convergence

Technical Items in this ModuleThe non-credit elements in the total analysis of payment certainty: liquidity, basis, market, operational risk

The expanded set of performance metrics: volatility, correlation; duration, convexity

The expanded set of solutions: contingent claims modeling; Monte Carlo simulation; Gaussian Copula

Competitor paradigms of credit analysis

The credit derivatives market: products, vocabulary, metrics of credit default modeling

Synthetic vs. Analytical Approaches

early framework

EraForward ApproachInverse Approach

pre-1900Ratings

mid-1900Financial statement analysisValuation of conditional claims

1970s-Black-Scholes model &

related algorithms

1980sCash securitization analysis-

post-1990Focus on liquidity/priceFocus on credit

measures

TermMeasuresDomain

Credit RiskdelinquencyBACEN Regulation 2682; some securitizations

default ratecorporation credit

1-year loss ratecredit generally

cumulative loss ratesecuritizations

historical maximacredit generally

loss distributionsecuritizations

Liquidity Riskfinancial ratioscredit generally

open positionsexchange-traded markets

Market Riskvariancegenerally where price is the figure of merit

m. duration/convexitysecuritizations

Basis Riskvarianceinter-market variation

Operational Riskinformalerrors due to non-of-the-above

servicer ratingssecuritizations

frameworks

CausalEmpirical

WhereCash securitization analysisTraditional "financial engineering"

HowRating agency & proprietary methodsOption-theoretic framework

WhoRating agenciesTraders & "geeks"

WhatIndepth analysis of unpublishedTraded prices and other liability-side

asset-side performance dataperformance data

WhenWith the payment periodicityContinuous

WhyThere is a unique solutionThere are many candidate solutions

Measures of Risk, by Domain

macro

micro

TermMeasuresDomain

Credit RiskdelinquencyBACEN Resolution 2682; some securitizations

default ratecredit baskets & single-names

1-year loss ratecredit from an accounting perspective

cumulative loss ratesecuritizations

historical maximacorporation credit

loss distributionsecuritizations

correlation coefficientcredit portfolios

Liquidity Riskfinancial ratioscredit generally

open positionsexchange-traded markets

Market Riskvariancemarket & credit

m. duration/convexitymarket

Basis Riskvariancemarket (inter-market variation)

Operational Riskinformalmarket & credit

servicer ratingssecuritizations

Sheet3

Credit RiskMeasures currently in use:

(1) Defaultan estimate of the probability that a borrower will not repay all or a portion of a loan on time (OTS);an ISDA credit definition;an empirical point-estimate taken from static pool historya random deviate from a distribution (or guesstribution)

Credit Risk (alt)(2) Lossan estimate of the shortfall on a financial contractual amount due (originally signified assets, now also signifies liabilities) after recoveries are netted from defaultsan input into the IRB risk-weighting model to produce a capital chargean output of a Vasicek-type credit risk modela point-estimate taken from static pool historya statistical point-estimate on a logistic curve

(3) Reduction of Yield: difference between the sample average yields in a Monte Carlo simulation and a contractual or target yield.

DiscussionRating agency ratings map all three types of measure to the alphanumeric rating. They are by no means interchangeable:

They are unlike in their information efficiency: IRR is fungible, can be compared to other yields; E(L) has more information than defaults but it can be manipulated by changing the recovery assumption; Default-based analysis over-states high frequency/low severity events and understates low frequency/high severity events. It is the furthest from the cash flow analysis.

Each produces a different numeric and a different rating:

early framework

EraForward ApproachInverse Approach

pre-1900Ratings

mid-1900Financial statement analysisValuation of conditional claims

1970s-Black-Scholes model &

related algorithms

1980sCash securitization analysis-

post-1990Focus on liquidity/priceFocus on credit

measures

TermMeasuresDomain

Credit RiskdelinquencyBACEN Regulation 2682; some securitizations

default ratecredit baskets & single-namest

1-year loss ratecredit from an accounting perspective

cumulative loss ratesecuritizations

historical maximacorporation credit

loss distributionsecuritizations

correlationcredit portfolios

Liquidity Riskfinancial ratioscredit generally

open positionsexchange-traded markets

Market Riskvariancemarket & credit

m. duration/convexitymarket

Basis Riskvariancemarket (inter-market variation)

Operational Riskinformalmarket & credit

servicer ratingssecuritizations

security-level measures

RatingClass AClass B

DIRRAA+/Aa1B+/B1

E(L)AA+/Aa1BB/Ba2

DefaultAA+/Aa1B-/B3

frameworks

Forward ApproachInverse Approach

WhereCash securitization analysisTraditional "financial engineering"

HowRating agency & proprietary methodsOptions-Theoretic Framework

WhoRating agenciesTraders & "Geeks"

WhatIndepth analysis of unpublishedTraded prices and other liability-side

asset-side performance dataperformance data

WhenPayment periodicityContinuous

WhyThere is a unique solutionThere are many candidate solutions

Liquidity RiskThe term specifies very different contexts:

The risk of a companys working capital becoming insufficient to meet near term financial demands. (Treasury Management Association of Canada)

The risk associated with transactions made in illiquid markets. Such markets are characterized by wide bid/offer spreads, lack of transparency and large movements in price after a deal of any size. (Federal Home Loan Bank of Dallas)

Market RiskRisk associated with fluctuations in (asset) prices (Minnesota Mutual)The possibility that the price of a security will change over time (David Gerster)A random walk, or, equivalently, Geometric Brownian motion

Most simply written

where the first term signifies the expected rate of change with respect to time and the second term signifies deviations from the first term that are normally distributed error terms. Prices in equilibrium are assumed to move as

Basis RiskA risk that the value of the financial instrument does not move in line with the underlying exposure. Generally, it refers to an imperfect hedge where the matched risk-offsetting positions are not in identical markets (Capital Market Risk Advisers)

Generally presumed to be less risky than outright market risk exposurebut data granularity is important. When the markets stop moving in tandem, the magnitude of risk is outside expectation.

Operational RiskAccording to 644 of International Convergence of Capital Measurement and Capital Standards, known as Basel II, operational risk is defined as the risk of loss resulting from inadequate or failed internal processes, people and systems, or f

Recommended