Mortgage Valuation Models: Embedded Options, Risk, and Uncertainty


Mortgage-backed securities (MBS) are among the most complex of all financial instruments. Analysis of MBS requires blending empirical analysis of borrower behavior with the mathematical modeling of interest rates and home prices. Over the past 25 years, Andrew Davidson and Alexander Levin have been at the leading edge of MBS valuation and risk analysis.

Mortgage Valuation Models: Embedded Options, Risk, and Uncertainty contains a detailed description of the sophisticated ...

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Mortgage-backed securities (MBS) are among the most complex of all financial instruments. Analysis of MBS requires blending empirical analysis of borrower behavior with the mathematical modeling of interest rates and home prices. Over the past 25 years, Andrew Davidson and Alexander Levin have been at the leading edge of MBS valuation and risk analysis.

Mortgage Valuation Models: Embedded Options, Risk, and Uncertainty contains a detailed description of the sophisticated theories and advanced methods that the authors employ in real-world analyses of mortgage-backed securities. Issues such as complexity, borrower options, uncertainty, and model risk play a central role in the authors' approach to the valuation of MBS. The coverage spans the range of mortgage products from loans and TBA (to-be-announced) pass-through securities to subordinate tranches of subprime-mortgage securitizations. With reference to the classical CAPM and APT, the book advocates extending the concept of risk-neutrality to modeling home prices and borrower options, well beyond interest rates. It describes valuation methods for both agency and non-agency MBS including pricing new loans; approaches to prudent risk measurement, ranking, and decomposition; and methods for modeling prepayments and defaults of borrowers.

The authors also reveal quantitative causes of the 2007-09 financial crisis and provide insight into the future of the U.S. housing finance system and mortgage modeling as this field continues to evolve. This book will serve as a foundation for the future development of models for mortgage-backed securities.

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Editorial Reviews

From the Publisher
"Mortgage Valuation Models delivers much more than its title suggests. It explores the key aspects of the mortgage market that ultimately were a trigger of the financial crisis. It offers potential policy solutions to remedy deficiencies in the current market structures. Most of all, though, alongside its very rigorous treatment of the technical details of mortgage models, it provides frequent illustrations and guidance that will help readers to avoid having unrealistically high expectations of their mortgage models." —Mark Adelson, Chief Strategy Officer, BondFactor Company

"This book is written by two top MBS experts who look at and far beyond the OAS relative value methodology. Davidson and Levin explain why mortgage instruments are valued at different OAS levels and how this is related to model risk and uncertainty. They demonstrate how to extend the idea of risk-neutral valuation to modeling both borrower prepayment behavior and default behavior, a major addition to the toolkit of MBS portfolio managers and traders. The book provides many important insights and analyzes the 2007-2009 crisis rigorously and quantitatively." —Frank J. Fabozzi, Professor of Finance, EDHEC Business School; Editor, The Journal of Portfolio Management

"This book is excellent. It combines a rigorous treatment of mortgage valuation models with a practical sense of what is important. It is easily comprehensible both to those familiar with the mortgage market and to those with reasonable quantitative backgrounds who are not. The chapters on the financial crises are particularly interesting, describing some of the trends that were overlooked in model calibration." —Laurie Goodman, Director, Housing Finance Policy Center, Urban Institute

"It is gratifying to see how prepayment modeling for mortgage-backed securities has evolved from statistical analysis of historical data to recognizing that refinancings are the result of rational option exercise by borrowers. Davidson and Levin do a commendable job of bringing us up to date, providing along the way an insightful perspective of the 2008-2009 mortgage crisis and the subsequent regulatory developments around housing finance." —Andrew Kalotay, President, Andrew Kalotay and Associates, Inc.

"Davidson and Levin offer their MBS valuation modeling framework as well as insights on the financial crisis and housing finance reform. As the housing market, mortgage industry and related governmental policies change, our MBS modeling needs evolve, too. This book places particular emphasis on modeling uncertainty during regime shifts. This intellectually stimulating book provides market participants with the tools to conceptualize these issues." —Jiawei "David" Zhang, Managing Director/Head of MBS Modeling, Credit Suisse

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Product Details

Meet the Author

Andrew Davidson is a financial innovator and leader in the development of financial research and analytics. He has worked extensively on mortgage-backed securities product development, valuation, and hedging. He is president of Andrew Davidson & Co., Inc., a New York firm specializing in the application of analytical tools to investment management, which he founded in 1992. He is co-author of the books Securitization: Structuring and Investment Analysis and Mortgage-Backed Securities: Investment Analysis & Valuation Techniques. He has also contributed to The Handbook of Mortgage-Backed Securities, Mortgage-Backed Securities: New Applications and Research, and The Journal of Real Estate Finance and Economics. He received an M.B.A. in Finance at the University of Chicago and a B.A. in Mathematics and Physics at Harvard University.

Alexander Levin is Director of Financial Engineering at Andrew Davidson & Co., Inc. He has developed innovative and efficient valuation models for mortgage-backed securities, including the Active-Passive Decomposition burnout model, the concept of prepay risk-and-option-adjusted valuation, and the method of Credit Option-Adjusted Spread and non-Monte Carlo shortcuts. His recent work focuses on the valuation of instruments exposed to credit risk, home-price modeling, and projects related to the MBS crisis. Levin has been a guest speaker at both academic and practitioner events and has published a number of papers. Levin is a recipient of the 2014 Mortgage Banking Magazine's Technology All-Stars award. He holds an M.S. in Applied Mathematics from Naval Engineering Institute, Leningrad, and a Ph.D. in Control and Dynamic Systems from Leningrad State University.

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Table of Contents


Part 1 Fundamentals of MBS Risk and Valuation
Chapter 1 Dimensions of Uncertainty
Chapter 2 Fundamentals of Securitization
Chapter 3 Investors in Mortgage-Backed Securities
Chapter 4 Valuation with Risk Factors and Risk Neutrality
Chapter 5 Short-Rate Term-Structure Modeling
Chapter 6 Risk-Neutral Modeling Using Forward and Futures Prices

Part 2 Modeling and Valuation of Agency MBS
Chapter 7 Agency Pool Prepayment Models
Chapter 8 Engineering of Valuation Models without Simulations
Chapter 9 Monte Carlo Methods
Chapter 10 Applications of the OAS Valuation Approach to Agency MBS
Chapter 11 Prepayment Risk Neutrality (the concept of prOAS)

Part 3 Modeling and Valuation of Non-Agency MBS
Chapter 12 Loan Level Modeling of Prepayment and Default
Chapter 13 The Concept of Credit OAS
Chapter 14 Empirical Modeling of Home Prices
Chapter 15 Credit Analysis on a Scenario Grid and Analytical Shortcuts

Part 4 Analysis of the 2008-2009 Financial Crisis
Chapter 16 Lesson #1: The Role of Financing and Affordability in the Formation of Housing Prices
Chapter 17 Lesson #2: The CDO Calamity and Six Degrees of Separation
Chapter 18 Lesson #3: Fair versus Intrinsic Valuation under Market Duress

Part 5 Building a Healthy Housing Finance System
Chapter 19 How to Measure Risk, Rank Deals and Set Aside Capital
Chapter 20 How to Price New Loans
Chapter 21 The Future of Housing Finance and MBS Modeling


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