![Introduction to Asset Modeling 27
Tuesday, September 11, 2012Valuation Actuary Symposium
Types of CDOs
§ Structured finance securities (mortgage-backed
securities, home equity asset-backed securities,
commercial mortgage-backed securities)
§ Leveraged loans
§ Corporate bonds
§ Real estate investment trust (REIT) debt
§ Commercial real estate mortgage debt (including whole
loans, B notes, and Mezzanine debt)
§ Emerging-market sovereign debt
§ Project finance debt
§ Trust Preferred securities
53
Interest Rate Derivatives
§ Notional amount applied to some
combination of reference rates and strike
rates
§ Cap: Notional x max ( reference rate - strike
rate, 0 )
§ Floor: Notional x max ( strike rate – reference
rate, 0 )
§ Swap: Notional x [ reference rate(1) –
reference rate(2) ]
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2012-la-val-act-49
- 1. 2012 Valuation Actuary Symposium Sept. 10- 11, 2012 Session #49 PD: Introduction to Asset Modeling Concepts Yidong Liu, FSA, MAAA Gregory J. Roemelt, FSA, MAAA Moderator Guillaume Briere-Giroux, FSA, MAAA Primary Competency Technical Skills & Analytical Problem Solving
- 2. Introduction to Asset Modeling 1 Tuesday, September 11, 2012Valuation Actuary Symposium ASSET MODELING 1 Greg Roemelt Winter Liu September 11, 2012 Need for Asset Models § Cash flow testing § ALM work § Financial plan § Capital planning § RBC calculations § SOP 03-1 § Principle based reserves 2
- 3. Introduction to Asset Modeling 2 Tuesday, September 11, 2012Valuation Actuary Symposium Purpose of Session § Agenda ú Building blocks of asset models ú Common asset classes and modeling considerations ú Reinvestment / disinvestment § Exclusion ú Only focus on the general account ú Will not include a discussion of interest rate or equity scenario generators 3 Fundamental Asset Components § An asset model tracks three fundamental components of any underlying assets ú Interest § Coupon frequency § Coupon rate § Reference rate ú Principal § Scheduled amortization § Call / put / prepayment § Default § Maturity § Sales ú Value § Par § Book § Market 4
- 4. Introduction to Asset Modeling 3 Tuesday, September 11, 2012Valuation Actuary Symposium Fundamental Asset Components § An asset model tracks three fundamental components of any underlying assets ú Interest § Coupon frequency § Coupon rate § Reference rate ú Principal § Scheduled amortization § Call / put / prepayment § Default § Maturity § Sales ú Value § Par § Book § Market 5 Asset Class Yield Curves § Use of asset yield curves ú Calculate market value ú Determine yields on reinvestments ú Basis for exercise of financial options § Model asset yield curves ú Treasury yield curve + asset spread 6
- 5. Introduction to Asset Modeling 4 Tuesday, September 11, 2012Valuation Actuary Symposium Model Asset Yield Curve § Treasury yield curve § Published daily § Can be modeled deterministically or stochastically § Asset spreads are the incremental amounts added to treasury rates to get the yields for risky asset ú Readily available for frequently traded assets ú Vary by various risk factors ú Typically modeled deterministically ú Typically use initial spreads based on market conditions and grade to long term averages 7 Asset Spreads Vs. Treasury 8 0 1 2 3 4 5 6 7 8 9 10 1-Dec-91 1-Aug-92 1-Apr-93 1-Dec-93 1-Aug-94 1-Apr-95 1-Dec-95 1-Aug-96 1-Apr-97 1-Dec-97 1-Aug-98 1-Apr-99 1-Dec-99 1-Aug-00 1-Apr-01 1-Dec-01 1-Aug-02 1-Apr-03 1-Dec-03 1-Aug-04 1-Apr-05 1-Dec-05 1-Aug-06 1-Apr-07 1-Dec-07 1-Aug-08 1-Apr-09 1-Dec-09 1-Aug-10 1-Apr-11 1-Dec-11 1-Aug-12 BBB Bond 10yrTreasury
- 6. Introduction to Asset Modeling 5 Tuesday, September 11, 2012Valuation Actuary Symposium Asset Spreads Consideration § Credit rating § Maturity § Liquidity § Embedded option ú May be more difficult to develop 9 Sample Bond Credit Spreads AA A BBB 90-Day 95 125 140 1-Yr 120 150 160 2-Yr 130 160 175 3-Yr 140 170 190 5-Yr 150 180 210 10-Yr 160 190 230 30-Yr 190 220 260 10
- 7. Introduction to Asset Modeling 6 Tuesday, September 11, 2012Valuation Actuary Symposium Asset Default § Vary by asset class and credit rating § Level or by duration ú Level: could vary by years to maturity ú Duration: increasing rates with age § Probability times severity § “Fallen Angels” 11 Model Defaults § Modeled as a reduction in book value ú 20 bps annual default assumption translates to a 0.2% annual reduction in book value § Modeled as a reduction to investment income ú 5.25% coupon with a 20 bps annual default assumption generates 5.05% income § Deterministic vs. Stochastic § Linked to interest rate? 12
- 8. Introduction to Asset Modeling 7 Tuesday, September 11, 2012Valuation Actuary Symposium Default Assumption § Default assumption – sources of data ú Moody's ú S&P ú Wall street ú Company experience/investment advisors 13 Asset Classes ú Non-callable bonds ú Callable bonds ú Inflation indexed bonds ú Mortgages and mortgage pass-through's ú Collateralize mortgage obligations (CMOs) ú Asset Back Securities (ABS) ú Collateralize debt obligations (CDOs) ú Derivatives 14
- 9. Introduction to Asset Modeling 8 Tuesday, September 11, 2012Valuation Actuary Symposium Non–Callable Bonds § Required data ú Book value (Stat, tax, GAAP) ú Par value ú Maturity date ú Coupon – rate and mode ú Sinking fund schedule § Other useful data ú CUSIP ú Market value 15 Non–Callable Bonds – Cash Flows § Fairly simple to project § Interest payment ú At coupon date: Cash Flow = Par x Coupon / Mode § Principal payment ú If sinking fund date, scheduled amount ú At maturity, Par 16
- 10. Introduction to Asset Modeling 9 Tuesday, September 11, 2012Valuation Actuary Symposium Non–Callable Bonds – Cash Flows Date Par – BOY Coupon Sinking Fund Total CF 12/31/2008 $10,000 $500 $2,000 $2,500 12/31/2009 $8,000 $400 $2,000 $2,400 12/31/2010 $6,000 $300 $2,000 $2,300 12/31/2011 $4,000 $200 $2,000 $2,200 12/30/2012 $2,000 $100 $2,000 $2,100 17 Non–Callable Bonds – Investment Income § Cash flow § Change in investment income due & accrued § Amortization of premium/accrual of discount ú Yield is not equal to coupon if book not equal to par 18
- 11. Introduction to Asset Modeling 10 Tuesday, September 11, 2012Valuation Actuary Symposium Non-callable bonds – Investment Expenses § Sources of assumption ú Annual Statement – Exhibit 2 ú Investment advisors § May vary by asset category ú Bonds ú Mortgages ú Real estate ú Policy loans 19 Non-callable Bonds – Market Values § Present value of future cash flows § Based on assumed asset category yield ú Treasury yield + asset spread ú Yield and spread tied to average life § Market value calibration ú Calculated MV likely differs from reported MV ú Additional spread calculated to calibrate ú Ignore, maintain or grade additional spread 20
- 12. Introduction to Asset Modeling 11 Tuesday, September 11, 2012Valuation Actuary Symposium Callable Bonds § Similar to non-callable, except issuer of the bond has the right (option) to call (pay off) the bond at some future date(s) § May be callable at a point in time (European option), or may be callable over a period of time (American option) § May be a “call premium” 21 Callable Bonds § Higher coupon than comparable non-callable bond § Difference is price of call option § Purchaser of bond has sold a call option to issuer of the bond 22
- 13. Introduction to Asset Modeling 12 Tuesday, September 11, 2012Valuation Actuary Symposium Callable Bonds – Cash Flows § If bond is not called, identical to non-callable § Call behavior ú Driven by interest rates ú Present value of cash flows at current rates VS. call price plus any refinancing cost ú The more “in the money” the call, the more likely the bond will be called ú Easier (or cheaper) for high grade lenders to refinance 23 Callable Bonds – Market Values § Much more difficult to calculate § Include the price of the call option § No closed form solutions for American calls § Multiple scenario / binomial lattice methodology 24
- 14. Introduction to Asset Modeling 13 Tuesday, September 11, 2012Valuation Actuary Symposium Treasury Inflation-Protected Securities (or TIPS) § Coupon is fixed § Principal adjusted to the Consumer Price Index 25 Mortgages § Property type ú Commercial ú Residential § Amortization Pattern ú Amortizing ú Non-Amortizing (interest only) ú Balloon § Interest Rate ú Fixed ú Floating 26
- 15. Introduction to Asset Modeling 14 Tuesday, September 11, 2012Valuation Actuary Symposium Quality of Underwriting – Residential Mortgages § Conforming mortgage ú Strict standards Amount Down payment Income Credit history Property condition § Non – conforming loans ú Alt-A ú Subprime 27 Mortgages – Cash Flow § Interest only – identical to bullet bond § Amortizing – Payment to amortize ú Loan period for non-balloon ú “Amortization period” for balloon ú Payment recalculated for ARM 28
- 16. Introduction to Asset Modeling 15 Tuesday, September 11, 2012Valuation Actuary Symposium Outstanding Principal 0% 10% 20% 30% 40% 50% 60% 70% 80% 90% 100% 0 3 6 9 12 15 18 21 24 27 30 Period Principal 29 Outstanding Principal Period CashFlow Interest Principal Total 30
- 17. Introduction to Asset Modeling 16 Tuesday, September 11, 2012Valuation Actuary Symposium Prepayments § Mortgagees frequently have the right to pay off or “prepay” mortgage § Residential – usually no prepayment penalty § Commercial – lock out period and “Make Whole” provisions 31 Factors Influencing Prepayments § Refinancing incentive ú Current rateVS. market rate + refinancing cost § Age of the mortgage § Seasonality § Burnout 32
- 18. Introduction to Asset Modeling 17 Tuesday, September 11, 2012Valuation Actuary Symposium Public Securities Assoc (PSA) Prepayment Model § Increasing prepayment amounts for 30 months § Constant thereafter at 6.0% per year § Not based on hard data § Used as industry standard pattern 33 100% PSA 0% 1% 2% 3% 4% 5% 6% 7% Months ConstantPrepaymentRate 34
- 19. Introduction to Asset Modeling 18 Tuesday, September 11, 2012Valuation Actuary Symposium Principal Payments – 100% PSA 0.0 1.0 2.0 3.0 4.0 5.0 6.0 7.0 PrincipalPayments Month 35 Mortgages – Market Value Calculations § Can be pricing using a constant PSA § MonteCarlo techniques more robust but more time consuming § “Model” similar mortgages to develop a market to book ratios, apply to all modeled § Outside systems 36
- 20. Introduction to Asset Modeling 19 Tuesday, September 11, 2012Valuation Actuary Symposium Mortgage Passthrough Securities § An asset-backed security whose cash flows are backed by the principal and interest payments of a set (pool) of mortgage loans § Holders of MBS share proportionally in the cash flows of the mortgage pool 37 Description of Pools § Type of collateral ú Agency ú Whole loan § WeightedAverage Coupon (WAC) ú Average of all the coupons in the mortgage pool, weighted by principal ú Will tend to decrease over time ú Always higher than the “passthrough rate” § WeightedAverage Maturity (WAM) ú average of the maturities of the mortgages in the pool 38
- 21. Introduction to Asset Modeling 20 Tuesday, September 11, 2012Valuation Actuary Symposium Modeling MBS § Similar to modeling regular mortgages § Default assumptions different if agency backed § Careful to model prepayments based on the weighted average coupon and not the passthrough rate 39 Collateralize Mortgage Obligations (CMOs) § ACMO is essentially a way to create many different kinds of bonds from the same mortgage pool so as to please many different kinds of investors. § CMO is a Special Purpose Entity ú Legal owner of a set of mortgages, called a pool. ú Investors buy bonds (tranches) issued by the entity ú Payments to the investors made based on a defined set of rules, called the structure 40
- 22. Introduction to Asset Modeling 21 Tuesday, September 11, 2012Valuation Actuary Symposium Types of CMO Tranches § Sequentials § PACs/TACs § Z tranche § Principal Only § InterestOnly 41 Sequential CMOs § FirstCMOs § Pay principal sequential to tranches § Purpose was to create short, medium and long term out of a single mortgage pool 42
- 23. Introduction to Asset Modeling 22 Tuesday, September 11, 2012Valuation Actuary Symposium Sequential CMO Principal Payments – 100% PSA 0.0 1.0 2.0 3.0 4.0 5.0 6.0 7.0 PrincipalPayments Month 43 Principal Payments 100% and 350% PSA 0.0 2.0 4.0 6.0 8.0 10.0 12.0 14.0 16.0 18.0 20.0 PrincipalPayments Month PAC Schedule 100% PSA 350% PSA 44
- 24. Introduction to Asset Modeling 23 Tuesday, September 11, 2012Valuation Actuary Symposium Principal Payments – 100 PSA 0.0 2.0 4.0 6.0 8.0 10.0 12.0 14.0 16.0 18.0 20.0 PrincipalPayments Month PAC Support 45 Principal Payments – 350 PSA 0.0 2.0 4.0 6.0 8.0 10.0 12.0 14.0 16.0 18.0 20.0 PrincipalPayments Month PAC Support 46
- 25. Introduction to Asset Modeling 24 Tuesday, September 11, 2012Valuation Actuary Symposium Principal Payments – 600 PSA 0.0 2.0 4.0 6.0 8.0 10.0 12.0 14.0 16.0 18.0 20.0 PrincipalPayments Month PAC Support PAC Schedule 47 Principal Payments – 50 PSA 0.0 2.0 4.0 6.0 8.0 10.0 12.0 14.0 16.0 18.0 20.0 PrincipalPayments Month PAC Support PAC Schedule 48
- 26. Introduction to Asset Modeling 25 Tuesday, September 11, 2012Valuation Actuary Symposium PACs – Cash Flow Priorities § Model cash flows of underlying mortgage pool § Allocate principal payments to “Most Protected” PAC § Allocate principal payments to “Less Protected” PAC § If principal remaining, allocate to support tranches § If principal remaining, allocate to “Less Protected” PAC § If principal remaining, allocate to “Most Protected” PAC 49 Asset Backed Securities § Home Equity Loans § Auto Loans § Manufacture Housing § CreditCards § Student Loans § Equipment Leases § OtherAssets 50
- 27. Introduction to Asset Modeling 26 Tuesday, September 11, 2012Valuation Actuary Symposium Modeling CMO & ABS § Key consideration ú CMOs tranche prepayment risk ú ABS tranche default risk ú Model underlying collateral ú Allocate principal based on structure § Typically difficult to model in-house 51 Collateralized Debt Obligations (CDOs) § Similar to ABS, but collateral is a wide variety of financial instruments § Modeling strategy is the same: ú Project cash flows of underlying collateral ú Use CDO structure to parse cash flows amongst various classes within the CDO § Complexity Risk 52
- 28. Introduction to Asset Modeling 27 Tuesday, September 11, 2012Valuation Actuary Symposium Types of CDOs § Structured finance securities (mortgage-backed securities, home equity asset-backed securities, commercial mortgage-backed securities) § Leveraged loans § Corporate bonds § Real estate investment trust (REIT) debt § Commercial real estate mortgage debt (including whole loans, B notes, and Mezzanine debt) § Emerging-market sovereign debt § Project finance debt § Trust Preferred securities 53 Interest Rate Derivatives § Notional amount applied to some combination of reference rates and strike rates § Cap: Notional x max ( reference rate - strike rate, 0 ) § Floor: Notional x max ( strike rate – reference rate, 0 ) § Swap: Notional x [ reference rate(1) – reference rate(2) ] 54
- 29. Introduction to Asset Modeling 28 Tuesday, September 11, 2012Valuation Actuary Symposium Equity Derivatives § Typically only modeled for specific products (e.g., FIA) § Pricing difficult § Options/derivatives as a reinvestment asset 55 Validation of Asset Models § Starting values ú Book ú Par ú Market § PortfolioYield § Cash flow analysis ú Principal payments ú Interest payments ú Calls/Prepayments ú Defaults § Policy loans 56
- 30. Introduction to Asset Modeling 29 Tuesday, September 11, 2012Valuation Actuary Symposium Typical Modeling Approach by Asset Class § Model seriatim in-house ú Bonds ú Mortgages & mortgage pass-through ú Interest rate derivatives ú Simple European equity options § Model via external vendors (EPA) ú CMO ú MBS ú CDO 57 Asset/Liability Interaction § Reinvestment § Disinvestment 58
- 31. Introduction to Asset Modeling 30 Tuesday, September 11, 2012Valuation Actuary Symposium Reinvestment Strategies - Basic § Define asset mix ú Asset class ú Credit rating ú Maturity § Rebalance ú No - Cash method ú Yes - Book method 59 Reinvestment Strategies - Conditional § Change over projection horizon ú E.g., invest in longer average duration in first five years, then shorter duration thereafter § Scenario driven ú E.g., invest in longer average duration when yield curve is normal (i.e., upward sloping) and switch to shorter duration when yield curve is inversed § Duration match ú Keep average asset duration within tolerance level to average liability duration 60
- 32. Introduction to Asset Modeling 31 Tuesday, September 11, 2012Valuation Actuary Symposium Reinvestment Strategies – Duration Match § Determine liability duration ú Pre-specified ú Dynamically calculated § Define tolerance & frequency § Define “duration match” portfolio ú Long vs. short ú Asset class (e.g., bonds, interest derivatives) § Allow rebalance? 61 Reinvestment Strategies – Duration Match Liability duration = Existing asset duration xWeight1 + “Match portfolio” duration xWeight2 § No rebalance: 0 < Weight2 < cash available § With rebalance: 0 <Weight2 < 1 62
- 33. Introduction to Asset Modeling 32 Tuesday, September 11, 2012Valuation Actuary Symposium Disinvestment Strategies § Selling assets ú Market value calculations ú Order of sales Existing vs. reinvested (or “model purchased“) By asset class – e.g., sell easier-to-value assets Pro rata vs. single assets (e.g., maximize gain) § Buying negative assets (borrowing from another Line of business) § Borrowing 63 Questions? 64