What would someone have to do to be able to price a structured product like Mortgage/Asset Backed Securities?
It may be a different from a buyside perspective, than from a sellside perspective.
Off course, I must add a caveat that this is based on my rather limited role and experience in this domain.
The sellside would have access to the complete dataset comprising the asset pool (to each single loan and mortgage).
The buyside would have a prospectus containing a lot of summarized info of the asset pool, but would not have access to info at each and every loan in the pool.
Cashflow Waterfall would be modelled by the sellside
This would be utilized to price the individual tranches and secure the credit rating for each of the tranches.
For the "cashflow waterfall", you will need to -
- aggregate the raw cashflows for each period from the payment profile of the pool of underlying assets.
- model defaults and prepayments. A simplistic way is to use a "Constant Default Rate" and and a "Constant Prepayment Rate" based on historical experience / statistical analysis.
compute the asset cashflows after applying defaults and prepayments
apply any credit enhancements to the cashflows
pay for priority payments, such as Trustee Fees
apply the covenants of the securitization tranches, taking seniority into account (this is the liabilities side, when you pay out of the asset cashflows period-wise). The tranches could be fixed or floating rate bonds, "Interest-Only" (IO) or "Principal-Only" (PO) tranches etc.
compute the remaining equity tranche, which constitutes the leftover cashflows after all debt obligations have been met.
compute the weighted average term of the securitization tranches.
subject the waterfall to stressed default and prepayment rates
Based on 8 and 9, a credit rating is obtained, pricing proposed. Weighted average term will give a point on the interest rate curve, for the indicative coupon. Stress testing and rating will provide a basis for a spread over the risk free rate. Similarly, impact of prepayments would significantly affect the IO and PO and will be priced in.
Buyside valuation assessment
It will be a cruder analysis, given less detailed information than available to sell-side. Benchmark similar securities, weighted average life, default and prepayment indicators will be factored in but in a less detailed fashion than a cashflow waterfall.