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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 Presentation

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  • 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