Bear Stearns introduced enhancements to its mortgage analytics models last week, with an eye to improving their prepayment, mortgage rate projection and term structure models.

Senior Managing Director V.S. Srinivasan said that Bear analysts made minor adjustments to their models' home price propagation to better account for the sensitivity to the media effect.

Meanwhile, the new term structure model is calibrated to best price the entire volatility cube, thus incorporating volatility skews, this is consistent both with skew swaption pricing and empirical market observations of how swaption volatilities change with interest rates. A key feature is that volatilities typically drop as rate rise and increase as rates fall. "Our new model captures this changing volatility both while propagating paths of future rates as well as in rate scenarios," said Gene Cohler, senior managing director at Bear. He added that modeling volatilities more accurately leads to improved pricing of the embedded options inside mortgages, which is key to calculating hedging metrics such as durations and convexities. These changes have been implemented in both the firm's OAS and Price of Risk Constant (PORC) framework, an in-house mortgage-pricing model.

In the same fashion, enhancements to Bear's mortgage rate projections model allow the firm to unify the mortgage rate process between its OAS and PORC models. An important aspect of the model is that mortgage rates exhibit a dampened and lagged response to a change in interest rates. This is why a positive shock to interest rates result in a smaller immediate change to the model's projected mortgage rates. But in subsequent months, over 95% of the initial rate shock would be filter through to the mortgage rate.

Analysts also updated their home price appreciation assumptions, calibrating short-term home price assumptions to the most recent Office of Federal Housing Enterprise Oversight year-over year national home price change, currently at 12.5%, reverting to a 3.5% assumption over a 36-month period. "We still expect home prices to outperform inflation by 50 to 75 basis points over the long run," said Srinivasan. However, he said that by using OFHEO data, they are able to align short-term prepayment projections with actual observed discount speeds.

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