Valuing Asset-Backed Securities Without Observed Market Prices

The Reserve Bank of Australia may purchase under reverse repurchase agreement asset-backed securities (ABS) which do not have an observable market price. This is particularly relevant for self-securitised residential mortgage-backed securities (RMBS)[1], which are RMBS retained by their originator. It also applies to self-securitisations backed by other assets, such as business loans. Self-securitised ABS are repo eligible under the Term Funding Facility. Self-securitised ABS may also be considered as acceptable collateral on a case-by-case basis for Exceptional Liquidity Assistance.[2]

The Reserve Bank undertakes prudent risk management of its counterparty exposures. For exposures collateralised by ABS without observed market prices, the Reserve Bank uses a valuation model to assign these securities a fair value consistent with the observed prices of similar marketed securities. The relevant margin ratios are applied to these fair value estimates to obtain the purchase price in reverse repurchase agreements for ABS without observed market prices (for details see Margin Ratios).

Valuing ABS can be more challenging than for other fixed income securities. This is because the timing of ABS cash flows is often not known with certainty; the security’s cash flows depend on the rate at which the underlying loans are repaid. The Reserve Bank’s valuation model uses weighted-average life (WAL) – which measures the average time until the principal of the security is repaid – as an estimate of the security’s effective life (or tenor) and values the security as a bullet fixed income security with the same tenor by applying an appropriate discount rate. This approach is consistent with common practices used by market participants to value pass-through ABS.

The key steps of the Reserve Bank’s valuation model for self-securitisations are outlined below.

  • Step 1: Each day, the Reserve Bank estimates the relationship between trading margins (the difference between the yield on the RMBS and the Australian dollar swap rate for the tenor corresponding to the WAL of the ABS) and key characteristics of marketed ABS deals: WAL, credit rating, seniority in the ABS transaction, originator type and certain information about the collateral pool, such as the share of low-documentation loans. Information on the key characteristics of each marketed ABS deal is sourced from the Reserve Bank’s Securitisation System.[3]
  • Step 2: Data for each self-securitisation – taken from the Securitisation System – are then used as inputs into the model in Step 1 to estimate a traded margin for the securities.
  • Step 3: The estimated trading margins for each self-securitisation (from Step 2), together with the Securitisation System-reported WAL and information on relevant interest rates, are then used in a standard Floating Rate Note (FRN) formula (see AFMA Debt Capital Market Conventions) to calculate fair values.

The Reserve Bank follows the approach outlined above in valuing self-securitisations without a market price when conditions in the Australian securitisation market are deemed to be normal.

The Reserve Bank may follow an alternative process that does not rely on estimating the appropriate trading margin from observed trading margins on comparable Australian ABS if the Reserve Bank forms the opinion that observed trading margins are not representative of the fair value for such securities.

For example, in March 2020 when there was substantial volatility in markets, the Bank decided to freeze the modelled prices of notes issued from self-securitisations for three years to mitigate the impact of price volatility on collateral values and margining frequency.

Endnotes

For a summary of structural features typically found in Australian RMBS, see Arsov I, I S Kim and K Stacey (2015), ‘Structural Features of Australian Residential Mortgage-backed Securities’, RBA Bulletin, June, pp43–58. [1]

<https://www.rba.gov.au/mkt-operations/resources/tech-notes/standing-facilities.html> [2]

Issuers of repo-eligible ABS are required to report data to the Securitisation System every month. These requirements were implemented to increase the information available to the Reserve Bank and the broader market and thus enhance transparency in the Australian securitisations market (for more information on these reporting requirements, see the RBA Securitisations Industry Forum). [3]