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Credit Modeling Tool to Aid Default and Prepay Analysis

Andrew Davidson & Co. Inc. has launched "Loan Dynamics Model," a credit valuation tool designed to project delinquency, default, loss severity and prepayment on non-agency mortgage loans, the fixed-income risk analytics provider said.

Company president Andrew Davidson said the Loan Dynamics Model is more than a new option, since it introduces an innovative approach to credit modeling, "standing at the threshold of a new era in mortgage loan dynamics modeling."

"We view that this is a scenario where this [credit modeling] is an area where there's going to be some dramatic evolution," he told MSN.

According to Mr. Davidson, "There is substantial agreement among analysts as to how the major factors interact," yet even though "prepayment models have become quite sophisticated over the past 20 years," credit modeling has not advanced "to the same level."

The models used by the industry today "are mostly scoring models that basically say this is a good loan, this is a bad loan, which is not to say they are simplistic," he explained. "They may have very complex features to them but they are not dynamic."

Both prepayment and credit modeling products tend to be expensive, but Mr. Davidson believes it is worth investing in loan security and understanding the dynamic nature of the risks one faces. He sees two main challenges to new credit tools, consistently getting good historical data and, more importantly, finding ways how to take the model and deliver it to the investor, primarily because there is a lot of data that needs to go into the analysis, plus there is a computation issue at the loan-level analysis.

"A combination of needing a lot of data and then a lot of computation makes it difficult to create and deliver analysis," he said. Users need to get a wide range of scenarios because to be able to see what the distribution of possible outcome is "and that takes a lot of computations."

The new LDM "is an important initial step," the company said, in its efforts to build "a sophisticated universally accepted Credit Product Line to help investors and issuers better understand credit and prepayment characteristics of mortgage loans and securities." To facilitate user access, LDM was built to be ready for integration into user's internal modeling systems, the company said, so it is "working closely with a number of its vendor partners."

LDM is part of the company's ongoing effort to expand beyond its current prepayment modeling service options to include sophisticated credit modeling that serve what appears to be a growing market demand. More specifically, it is targeting "the mounting needs of firms that issue or invest in credit-sensitive mortgages and related securities," such as alt-A, high loan-to-value loans and so-called subprime products.

"Our new Loan Dynamics Model provides a unified framework for analyzing and modeling the prepayment and default characteristics of the loan," he explained. "It incorporates the best features of traditional roll-rate models and discrete choice models. This framework allows us to understand mortgage loans as never before."

Launched in January at American Securitization Forum Conference in Las Vegas, LDM is one of several products that were finalized after two years of extensive research. The company said its development effort "resulted in a set of economic models" that explain borrower motivation when transitioning from one payment status to another, ranging from current to terminated, "given an assortment of economic scenarios and loan characteristics."

For instance, the development of the aforementioned Credit Product Line, the company said, also includes the Home Price Index generator, the Home Price Appreciation generator and the Implied Default Model, which are fully operative in-house, but still in development as "commercial" tools.

The HPI product serves to evaluate home price inflation. "In order to analyze default, it's good to know what's going on with home prices," Mr. Davidson told NMN. "If people are doing a stimulation of future interest rate scenarios, it allows them to generate future home prices that are consistent with and related to the interest rates they are generating."

So far, the company said, it has been used in-house only, but interested parties have the option to apply for a HPI license. It benefits users who want to link interest rate generators to the Loan Dynamics Model. The product, however, is considered in development, he said, since the goal is "to build it into a more formal valuation capability." (c) 2007 Mortgage Servicing News and SourceMedia, Inc. All Rights Reserved. http://www.mortgageservicingnews.com http://www.sourcemedia.com