QFIP 100 - Modeling of Mortgage Defaults

Question 1

Voluntary vs involuntary prepayments

Answer 1

• Voluntary: refinancing, housing turnover
• Involuntary: defaults

Question 2

Real estate owned (REO)

Answer 2

Lender takes possession of property

Question 3

ABX

Answer 3

A financial benchmark that measures the overall value of mortgages made to borrowers with subprime or weak credit (Investopedia)

Question 4

Determinants of Mortgage Defaults

Answer 4

• For a default to occur, both of the following must exist:

1. Homeowner is unable to make monthly mortgage payment (e.g. due to unemployment, family illness, excessive obligations)
2. Lack of equity in the home, so unable to refinance or sell home without a loss

Question 5

Standard Default Assumption (SDA) Curve

Answer 5

• Captures the pattern of mortgage default
• Historically, mortgage defaults rates have been low initially, rise for a few years, then decline after fairly seasoned
  
  • e,g,.Rise linearly for 30 months, stay level until month 60, then decline

Question 6

Current LTV

Answer 6

Estimated from the initial LTV using cumulative home price appreciation
(HPA) along with amortization

Question 7

Recent changes in home prices effect for seasoned mortgages

Answer 7

1. Housing market may be a proxy for general economic conditions
2. Servicers may try to minimize losses by encouraging short sales before the market drops more
3. Psychological impact could encourage homeowners to give up

Question 8

Valuation of Mortgage Credit Risk

Answer 8

• Need to combine a default model with a prepayment and loss severity model to get projected cumulative losses
• Defaults are really just a subset of prepayments
• Default Rates and CPR/CDR:
  
  • Higher prepayments reduce the overall balance and thus trim down the defaults
  • Higher voluntary CPR (total prepayment rate) tends to lead to lower default rates
  • Higher CDR (involuntary prepayment rate) tends to lead to higher default rates

Question 9

What is the most important economic factor in determining subprime mortgage
performance?

Answer 9

• HPA is the most important economic factor in determining subprime mortgage performance
• Losses are not as sensitive to unemployment and interest rate changes

Question 10

Prch mortgages

Answer 10

• the percentage of mortgages in a pool classified as purchase loans
• Generally seen as higher risk
• Purchase loans include a significant number of first-time inexperienced homebuyers, who are more likely to default on their loans
• Refinance loans, in constrast, are generally seen as less risky because these loans are from borrowers who already own a home, have made payments, and have built significant equity in their homes

Question 11

PiggyBack Mortgages

Answer 11

• the percentage of mortgages in a pool that are associated with a piggyback loan
• A piggyback loan occurs when a borrower takes out two loans simultaneously:
  
  • one for 80 percent of a home’s value,
  • and the other to make up for whatever cash is lacking to make up a 20 percent down payment
• Used as an alternative to private mortgage insurance