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), which are RMBS retained by their originator, that are eligible in the Reserve Bank's standing facilities.
The Reserve Bank undertakes prudent risk management of its counterparty exposures, including exposures collateralised by ABS without observed market prices. The Reserve Bank uses a valuation model for self-securitised RMBS, which in the opinion of the Reserve Bank assigns these securities a fair value consistent with the observed prices of similar marketed securities. The Reserve Bank uses an estimate of 90 dollars per 100 dollars of outstanding face value for the fair value of other ABS without an observed price. 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).
The Reserve Bank's valuation model for self-securitised RMBS utilises the data that are currently available, which are somewhat limited. It was partly with this limitation in mind that the Reserve Bank introduced the new reporting requirements for repo-eligible ABS, which will 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 the new reporting requirements, see the RBA Securitisations Industry Forum). The Reserve Bank will refine its valuation and risk management practices for ABS as the enhanced data become available, and progressively expand its model valuation to other ABS without observed market prices.
The key elements of the valuation model for self-securitised RMBS currently used by the Reserve Bank are outlined below.
As with any fixed income security, the fair value of an RMBS is the discounted value of its expected cash flows. However, valuing RMBS is more challenging than valuing bullet fixed income securities because most (Australian) RMBS are structured as pass-through securities. As a result, the timing of RMBS cash flows are not known with certainty, even in the case when there are no defaults and losses on the underlying collateral pool, because the security's cash flows depend on the rate at which the underlying mortgages are repaid.
A common approach used by market participants to value pass-through RMBS is to estimate an appropriate measure of the security's effective life (or tenor) and value it as a bullet fixed income security with the same tenor by applying an appropriate discount rate. The weighted average life (WAL), which measures the average time until the principal of the security is repaid, is used as the typical measure of the RMBS tenor in this case.
The Reserve Bank's model for valuing self-securitised RMBS is similar and involves two steps. In the first step, the model estimates the security's WAL. The future cash flows from the collateral pool of the RMBS transaction are modelled to estimate the future cash flows of all the notes in the RMBS transaction and, in turn, estimate the weighted average lives of each of these notes. Estimates of the principal repayments on the mortgages in the collateral pool are used to project the future principal payments to the notes in the RMBS transaction by taking into account the relevant structural features of the RMBS in allocating the principal payments across the structure of the transaction. The projections are made under the assumptions that: (1) the collateral pool is closed on the valuation date, as the self-securitised RMBS will be assigned a value when the counterparty to the repurchase agreement is in default and can no longer replenish the collateral pool; and (2) the prepayment rate on the mortgages is constant and the same as the observed prepayment rate on mortgages in similar marketed RMBS. Assumptions about the relevant structural triggers in the RMBS that may alter the security's payment priorities are made consistent with the observed determinants of these triggers at the valuation date (for example, the state of the serial paydown trigger often depends on arrears rates and in the valuation model it is based on the observed level of the relevant arrears rates on the valuation date).
In the second step, the model estimates the appropriate discount rate for the security, which in the case of RMBS is expressed as a trading margin – the difference between the yield on the RMBS and the Australian dollar swap rate for the tenor corresponding to the WAL of the RMBS. The estimated trading margin is consistent with observed trading margins in the market for marketed RMBS with similar characteristics to the self-securitised RMBS. On each valuation date, the Reserve Bank estimates the relationship between observed trading margins and the following characteristics of marketed RMBS: WAL, credit rating, seniority in the RMBS transaction, originator type and certain information about the collateral pool, such as the share of low-documentation loans. This observed relationship, together with the estimate of the WAL of the self-securitised RMBS from the first step, provide a fair value estimate of the trading margin for the self-securitised RMBS that could be obtained in the market. The estimated WAL and trading margin for each security, together with information on relevant interest rates, are used in a standard Floating Rate Note (FRN) formula (see AFMA Debt Capital Market Conventions) to calculate the self-securitised RMBS fair value.
While the Reserve Bank follows the approach outlined above in valuing RMBS without a market price when conditions in the Australian securitisation market are deemed to be normal, the Reserve Bank will follow an alternative process that does not rely on estimating the appropriate trading margin (and more broadly discount rates) from observed trading margins on comparable Australian RMBS if the Reserve Bank forms the opinion that observed trading margins are not representative of the fair value for such securities.
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.