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March 11, 2010

Improving valuation assumptions

by James West

Story link: Improving valuation assumptions

In this article, James West, a director in the new Valuation & Risk Strategies group at Standard & Poor’s Fixed Income Risk Management Services division, discusses the findings from the latest survey into structured finance market participants’ valuation assumptions and methodologies.

The results from the latest Valuation Consensus survey imply that investors are now more positive about the outlook for US and European house prices, predicting a bottoming for most housing markets before the end of 2010.

However, while predictions of default rate and loss severity on the collateral behind UK Prime and Non-Conforming Loan (NCL) residential mortgage backed securities (RMBS) have fallen significantly since the previous survey was conducted, at the end of Q3 2009, expectations for loss severity and default rate on all classes of US RMBS collateral have risen significantly.

The survey respondents, from the buy side and sell side of the structured finance market, include front office staff, portfolio managers, researchers, risk managers and credit analysts.

Every quarter they are asked about the precise valuation methodologies and input assumptions they use for all classes of US, European and Australian asset-backed securities (ABS) on an asset level, vintage level and on an individual deal level.

By comparing the results against previous quarters, it is possible to observe both investors’ changing predictions for the performance of RMBS collateral and any developing trends in valuation methodologies across the buy and sell side sides of the market.

The Valuation and Risk Strategies group in Standard & Poor’s Fixed Income Risk Management Services division (which operates independently from S&P’s credit ratings business) has been conducting these surveys since Q1 2009 with a view to accumulating enough data to create a benchmark of input assumptions and a consensus of methodologies, offering a set of standards around valuation that will assist people undertaking economic (or intrinsic) and market valuation of otherwise hard-to-value securities.

Indeed, it is widely acknowledged that improved transparency and consistency around the valuation of asset backed securities – in particular around the input assumptions used in cash-flow models for illiquid securitised assets – will help repair the damage done to investor confidence, and contribute towards the restoration of activity in the wider credit markets.

In fact, many of the investors surveyed over the past 12 months have stated there is a need to change the whole discipline of credit and risk valuation as it relates specifically to price and price risk.

In terms of US house price assumptions, the forecasts for the latest quarterly survey are slightly improved since the previous quarter, with a current consensus view for the bottoming out of the market in Q4 2010.

In the interim, US national home prices are expected to average a 5% decline, buoyed by expected growth in some regional markets.

House prices in Dallas, for example, are now forecast to experience an average 4% increase over the next 12 months, up from an average 5% decline forecast last quarter.

In the UK, the average 12-month prediction for house prices is a 5.8% decline – compared to a 7% fall forecast in Q3 2009.

Reinforcing this improving expectation, there has also been a marked tightening in the consensus around when the UK market will trough.

50% of respondents now anticipate the bottom of the market during Q4 2010, whereas in the previous survey no quarter garnered more than 20% of the vote.

Meanwhile, Dutch and Italian markets are also expected to trough before the year end but Spanish house prices are not predicted to hit a bottom until Q2 2011.

In terms of default rate assumptions on the underlying mortgage collateral, estimates on virtually all classes and vintages of US RMBS have increased significantly.

Indeed, US 2007 Alt-A Pay-Option ARM RMBS collateral default rate predictions have risen from 12% polled in Q3 to 25% polled in Q4; meanwhile, 2004 US Sub-Prime adjustable rate RMBS collateral default forecasts have moved out from 13% to 26%.

Prime fixed rate mortgage default rate forecasts have also risen on all vintages with the exception of 2004. 2006 estimates have increased from 3.6% to 5.7% and 2007 estimates from 4.0% to 5.8%.

These assumptions contrast with a marked improvement in expectations for default rates across all classes and vintages of UK RMBS collateral.

For UK Non Conforming Loan (NCL) RMBS collateral, the predicted rate for an average of vintages over the next 12 months is 4.61%, a fall from 9% polled in Q3. And for Prime UK mortgage default rates, the 12 month average forecast for all vintages also fell, from 2% in Q3 to just 1.09% now. Forecasts for Spanish, Italian and Dutch mortgage default rates also fell.

Likewise, estimations for loss severity (the severity of any losses incurred on the collateral in default) are also more pessimistic in the US. For all vintages of UK Prime RMBS, 12-month estimates dropped to 26.7% from 27.6% in Q3 and for NCL RMBS they dropped back to 33% from 36% in Q3.

In contrast, 12-month US Prime RMBS loss severity estimates have climbed close to the level of lower quality US mortgage classes. For 2005, 2006 and 2007 vintages, US Prime RMBS loss severity forecasts now average 59% (up from 47% polled in Q3), while in the same years loss severity expectations for US Alt-A RMBS are at 64% (up from 62% in Q3).

Deteriorating assumptions around US Prime RMBS may reflect the commonly held view that housing markets recover primarily at the bottom segment of the market.

It is possible that sales of lower-value properties triggered the housing trough but as higher-value properties begin to sell there could be further weakness in house prices in this upper segment of the housing market.

Furthermore, as higher value homes sit in foreclosure, servicers’ advanced payments to prop up the borrower may also help drive up loss severities if the property is ultimately liquidated and the property’s sale proceeds reimburse the servicer for these payments.

In terms of valuation methodologies, the results from the Q3 survey implied that buy side institutions in Europe were significantly more likely to examine collateral pool data than European sell side institutions.

In the Q4 survey, 75% of the European buy side state that they use loan-level data (down from 79%) versus 55% of the sell side (up from 52%).

Thus the results from Q4 may imply this imbalance is being redressed. However, the importance that each side of the European market now places on examining loan-level data has shifted more ambiguously – only a third of buy side participants now considers it “very important” (down from over 50% in Q3) – while 42% of sell side participants now attribute the same significance (up from only 25% in Q3).

It remains to be seen in the Q1 2010 survey whether these data reflect the beginning of a balancing out between the two sides’ focus on underlying collateral analysis.

When asked how their collateral default rate and pre-payment rate assumptions are constructed, the most important macroeconomic factors cited by respondents remain unemployment and interest rates.

However, determining when exactly default takes place is still an area of disagreement between the buy and sell side and between the US and UK markets.

43% of US respondents state that foreclosure (or repossession) is the point of default while a slight majority of US participants use delinquency as their point of default. In the UK, on the other hand, nearly 90% of the buy side considers default to occur at repossession, versus 47% of the sell-side.

In terms of how European participants’ valuation assumptions are mapped out in the future, 56% of both buy-side and sell-side institutions surveyed now use input assumptions that are vectored (rather than flat). This represents a convergence of approaches since the last survey when levels were 70% and 46% respectively.

If this reflects a trend towards increasing sell side sophistication – which may have also been inferred from the increasing importance the sell-side now puts on accessing loan level data – the same trend is also suggested by how participants construct their future loss severity assumptions.

63% of the European buy side now uses vectored inputs, up from 50% in Q3, while as much as 46% of the sell side is now using vectors for their loss severity inputs, up from 18% in Q3.

However, the buy side’s continuing bias for vectoring assumptions manifests itself in prepayment rate calculations, for which 56% of the buy-side uses vectors versus 31% of the sell-side.

Typically, European investors vector prepayment and default assumptions in six to twelve month increments over a three year horizon, after which point they are likely to adopt constant rates.

By comparison, due to the US market’s relative maturity, transparency and the availability of standardised data for each of these key credit metrics, half of the US participants polled use monthly vectors forecasting out as far as 30 years.

The Q4 survey also reveals how much new RMBS issuance is expected in 2010.

In the US, most participants feel that the total non-agency RMBS issuance will amount to less than $10 billion, and will exhibit traditionally Prime quality characteristics.

In the UK, for Prime UK RMBS, the consensus appears to be for between £11 billion and £25 billion of issuance. However, the remainder of the European buy side (33%) felt the figure would be more like £1-£10 billion, while the remaining sell side (29%) predicted as much as £25-£100 billion.

Certainly, the success of the primary market in 2010 depends to a large degree on issuers and their banks finding a receptive investor base.

The legacy of ABS assets in institutional and alternative investors’ portfolios in some cases precludes would-be buyers from entering the market. The requirement to value these assets in a defensible, robust manner remains a priority, whether for trading or indeed for holding to maturity.

The figures in this survey show that there remain concerns for the performance of some classes of mortgage collateral and, further, some disparities between the valuation approaches of different sides of the market. Indeed, trying to validate internal assumptions used for the valuation of structured finance assets remains a central challenge for investors and money managers today.

While it remains difficult to deliver truly comprehensive methods for security and portfolio valuation, encouragingly, the results from the latest survey also imply signs of converging valuation methodologies among participants the structured finance market.


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