Event

Event: Valuation of Mortgage-backed Securities by Coupled Lattice Efficiency Analysis
Date: May 16
Time: 6 pm
Location:
Goldman Sachs
10 Hanover Square
New York City

Description: The valuation of MBS is dominated by prepayment modeling. Prepayment projections are typically derived from historical data. Periods of rampant refinancings, such as the fall of 2001, inevitably give rise to “new and improved” prepayment models. “Burnout” (slow down following major refinancing) is modeled by changing parameters.

In our approach, we distinguish between “baseline“ prepayments that do not depend on interest rates and “refinancings” that do. Using the notion of refinancing efficiency, we categorize mortgagors across a wide spectrum of behavior. There are financial engineers who do it just right, leapers who refinance too early and laggards who wait too long.

We partition the mortgage pool into “efficiency buckets” and calibrate their sizes to market prices. As prepayments become known, the composition of the pool dictates the allocation of excess refinancings over the baseline. Leapers are eliminated first, then financial engineers, and finally laggards. As the pool ages, its composition gradually shifts towards laggards, and this automatically accounts for burnout.

A distinguishing feature of our approach is the rigorous analysis of mortgages. It requires an optionless mortgage yield curve — not explicitly observable but implied by market data. We represent mortgage rates and MBS rates as two perfectly correlated lattices: one determines mortgage refinancings; the other values the MBS. The formulation allows for recursive valuation that is orders of magnitude faster than conventional Monte Carlo analysis, resulting in increased accuracy and superior performance.