Abstract
Non-agency mortgage-backed securities (MBS) are typically priced and traded on discounted cashflow basis where a cashflow projection is made under a prepayment and default scenario and discounted with a discount margin (DM) that supposedly measures credit risk. Whilest simple and intuitive to traditional buy-and-hold investor base, it quickly became clear that DM was not effective for pricing and risk management, when mortgage credit rapidly grew out of usually mild credit environment and more sophisticated participants entered into the market. In particular, synthetic players' push for standardization of CDS on ABS and index products (ABX and CMBX) started to demand pricing consistency across cash and synthetics. In this paper we advocate application of portfolio credit derivative no arbitrage pricing framework to mortgage securitization products and their derivatives. To demonstrate we focus on the first toxic out of the Pandora's box into the financial system -- subprime MBS. We develop an amortizing mortgage loan model with competing arrival of random prepayment and default events following reduced form modeling of corporate default. Loan prepayment correlation, default correlation, and cross correlation can be built drawing into vast literature of corporate default correlation modeling. As both prepayment and default depend on house price appreciation and interest rate, we introduce a prepayment and default factor copula (Gaussian) to statically model these two factors. Analysis of recent vintage subprime deal structure reveals a near sequential pay waterfall which allows semi-analytical pricing of MBS. Calibration to ABX.HE benchmark is satisfactory and pricing of bespoke ABS off the index not only offers fair value data points when there is no market but also an innovative way to assess relative values. ABS CDO and TABX can be consistently priced with underlying ABS and the model naturally extends to CMBS/CMBX/CRE CDO and CLO/LCDX.
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