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© , Strategic Analytics Inc. Canary in the Coal Mine – What nonlinear dynamics based risk evaluation tells us about the US Mortgage Crisis – Why it is now being adopted by RMBS investors – Implications for Australia Joseph L. Breeden President & COO
2 © , Strategic Analytics Inc. Overview A Technology Introduction A History Lesson A Forecasting Example
© , Strategic Analytics Inc. A Technology Introduction – The Dynamics of Retail Portfolios
4 © , Strategic Analytics Inc. Vintage Lifecycle Components of Portfolio Performance
5 © , Strategic Analytics Inc. Vintage Lifecycle Credit Quality Components of Portfolio Performance
6 © , Strategic Analytics Inc. Vintage Lifecycle Credit Quality Seasonality Components of Portfolio Performance
7 © , Strategic Analytics Inc. Vintage Lifecycle Credit Quality Seasonality Management Actions Components of Portfolio Performance
8 © , Strategic Analytics Inc. Vintage Lifecycle Credit Quality Seasonality Management Actions Macroeconomic & Competitive Environment Components of Portfolio Performance
9 © , Strategic Analytics Inc. Vintage-level data is decomposed into functions of months-on-books (maturation), calendar date (exogenous), and vintage (quality). Nonlinear Decomposition
10 © , Strategic Analytics Inc. Point-in-Time Static Pool Modeling Segment using any information available at time of origination. Include vintage segmentation. Employ a model that can explicitly include lifecycle, credit quality, and environmental impacts. Distribution shifts in behavior scores are fully explained by these effects. ModelAnalysis LevelLifecycleCredit QualityEnvironment Survival¹Account, Terminal Events NonparametricApplication Scores, etc. Macroeconomic Factors Panel DataAccount, Any Events NonparametricApplication Scores, etc. Macroeconomic Factors Age Period Cohort Vintage, Any RateNonparametricNonparametric²Nonparametric³ Dual-time Dynamics Vintage, Any RateNonparametricNonparametric²Nonparametric³ ¹ Leveraging recent developments in Survival and Proportional Hazards Models. ² A nonparametric approach avoids problems with adverse selection, such as was seen in the US Mortgage Crisis. ³ A nonparametric approach avoids explaining all portfolio trends with macroeconomic data, which is a common occurrence in portfolio modeling. Macroeconomic factors are brought in after removing management actions.
11 © , Strategic Analytics Inc. Probability of Default (PD) or Default Rate (DR), Exposure at Default (EAD), and Loss Given Default (LGD) could all be analyzed via decomposition. For the rest of this analysis, we will focus on PD / DR and follow the Basel II approach with respect to EAD and LGD. Creating the Portfolio Forecast
© , Strategic Analytics Inc. A History Lesson – 2007—20?? Mortgage Crisis
13 © , Strategic Analytics Inc. Basel II QIS 4.0 Quantitative Impact Study 4 was conducted from 2004Q4 to 2005Q1 to assess capital requirements under the new Basel II guidelines. The results showed a 61% decrease in capital needs for mortgage and a 74% decrease for home equity.
14 © , Strategic Analytics Inc. Whenever interest rates drop, a refi and new home boom ensues – usually lasting 12 to 24 months After a boom, delinquency and foreclosure rates climb US Mortgage Boom and Bust Cycle Mortgage Originations60 Day Delinquencies
15 © , Strategic Analytics Inc. US Mortgage Meltdown 2007 The US Mortgage environment began to deteriorate in 2000 along with other consumer loan types. In 2001, a surge in home prices stopped the deterioration. By 2004, the overall economy was growing strongly, so US mortgage largely missed the last recesssion.
16 © , Strategic Analytics Inc. US Mortgage Meltdown 2007 The quality of originated mortgages shows three clear periods of deterioration since The 2000 deterioration is well known in the industry, but not well understood. The problems are in the news now. Vintage
17 © , Strategic Analytics Inc. US Mortgage Meltdown 2007 Today’s problems are not just due to fraud, Option ARMs, securitization, or subprime. Falling interest rates provide incentive for purchasing and refinancing. Rising home prices in 2001 and provided the justification for booking riskier loans. The economy does not control quality. It provides the motivation driving banks to change their targets and policies, which then affects quality in-the-door. Vintage
18 © , Strategic Analytics Inc. Mortgage Crisis Phases Phase 1 (2005): Originations quality deteriorates, but not seen by scores. Phase 2 (2007): House prices start to decline, so default severity rises rapidly. Phase 3 (2008): Liquidity crisis because securitization market collapses. Phase 4 (2008 Q4): General recession begins, increasing defaults. All US retail products experienced all 4 phases of this crisis. Subprime and Alt-A mortgages were simply the worst.
© , Strategic Analytics Inc. A Forecasting Example – US RMBS
20 © , Strategic Analytics Inc. Common Approaches to Forecasting are Inadequate Most Roll Rate models and score-odds calibrations do not employ “forward-looking” techniques and are rarely helpful beyond 6 months. They cannot explain impacts from economy or anticipate turning points. Models that assumed fixed macroeconomic relationships, or that scores fully explained quality, failed badly in the US Mortgage Crisis.
21 © , Strategic Analytics Inc. Losses have risen across all Mortgage Products Not surprisingly, Charge-off Rates for all products have risen quite significantly over the last 2 years. Charge-off Rates for 2yr ARMs have risen even more dramatically over the last 18 months. Loss Rate% Actual (by month)
22 © , Strategic Analytics Inc. Segment the Deals for Analysis Each deal is split into the 207,360 segments described below. Segmentation aids the creation of product-specific lifecycle and environmental curves.
23 © , Strategic Analytics Inc. These curves illustrate the lifecycle properties particular to the delinquency and loss rates. We typically see stacking of these curves by risk and product dynamics. Lifecycle of loan losses is one driving factor Loss Timing Curve (Lifecycle Effect)
24 © , Strategic Analytics Inc. These curves illustrate the lifecycle properties particular to the prepayment rate (generally due to refinancing). A general increase in prepayment activity after annual terms or rate resets can be clearly observed. Prepayments also show strong lifecycle effects Prepayment Timing Curve (Lifecycle Effect)
25 © , Strategic Analytics Inc. The exogenous component of the loss curve is largely driven by macroeconomic factors. After turning in mid-2006, the environment has steadily deteriorated over the last 24 months. The pace of deterioration has been the worst for Hybrid ARMs. Worsening Turning Point Deteriorating Environment is another strong factor Loss Timing Curve (Environment Effect) Lower Risk Higher Risk
26 © , Strategic Analytics Inc. Unemployment Rate House Prices The Exogenous curve shows strong relationships to Unemployment (positive correlation) and House Prices (negative correlation) Exploring Macroeconomic Drivers
27 © , Strategic Analytics Inc. Worsening Originations Quality is the third major factor Higher Risk Looking across various types of ARMs, we confirm that V2006 and V2007 have significantly worse underwriting than the historical portfolio. Compared to loans originated in 2005, V2006 is 140% worse and V2007 is 80% worse. This deteriorating quality was generally not captured by bureau scores. Loss Timing Curve (Originations Quality)
28 © , Strategic Analytics Inc. Portfolio losses were stressed with different outlooks for House Prices and Unemployment. They were combined via a multivariate weighting model to create the final Economic Response Model Baseline scenario sees a leveling-off of losses in 2009 and a gradual reduction in Recovery scenario sees an immediate reduction of losses starting in While the Severe Recession scenario sees a sharp rise in losses throughout 2009 with eventual curing occurring second half of Economic Stress Test Results Loss Rate% Forecast (by month)
29 © , Strategic Analytics Inc. Portfolio Forecasts Comparing Models Roll RatesDtD ModelActualsDtD Model “Lift” $102mm$217mm$246mm$115mm (113%) Note: Backtest was performed on Citibank Mortgage Securities totaling 50K Loans with $9B in Receivables. Citibank 30-year Fixed Loss% Forecast (monthly) History Roll Rates Flat Economy DtD Model Flat Economy Actuals With Economy
© , Strategic Analytics Inc. Conclusions
31 © , Strategic Analytics Inc. Conclusions Origins of the US Mortgage Crisis run deeper than lax underwriting and poor securities pricing. Scenario-based forecasting and allowance for adverse selection are required for proper pricing. Models already exist that can capture the dynamics of mortgage portfolios and properly forecast the securitized pools. DtD as implemented in LookAhead began showing dire forecasts for US Mortgage in February 2006 – this was predictable.
32 © , Strategic Analytics Inc. References Breeden, J. Reinventing Retail Lending Analytics: Forecasting, Stress Testing, Capital, and Scoring for a World of Crises. (2009) Riskbooks. Core Technology: Breeden, J. “Modeling data with multiple time dimensions”, Computational Statistics and Data Analysis, v. 51 (2007) pp Stress Testing: Breeden, J. “Survey of Retail Loan Portfolio Stress Testing”, in Stress Testing for Financial Institutions (2009) pp Breeden, J., L. Thomas, & J.W. McDonald III “Stress-testing Retail Loan Portfolios with Dual-time Dynamics”, Journal of Risk Model Validation, v. 2(2) (2008) pp Breeden, J. & L. Thomas “The Relationship Between Default and Economic Cycle Across Countries”, Journal of Risk Model Validation, v. 2(3) (2008) pp Breeden, J. “Validation of Stress Testing Models”, in The Analytics of Risk Model Validation (2008) pp Economic Capital: Breeden, J. & D. Ingram, “Monte Carlo Scenario Generation for Retail Loan Portfolios”, Journal of Operations Research (2009).
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