There is a disconnect between how the market prices residential mortgage-backed securities and their intrinsic value, according to a recent study by Fitch Solutions to gauge the factors driving the valuations of RMBS tranches.
The case study, entitled, "What Moves RMBS Tranche Values? A Case Study," compared observed valuations of RMBS bonds in the market with internally derived discounted cash flow valuations based on a range of default and loss assumptions.
One goal of the study was to find the loss assumptions that would cause the modeled price to converge with the market price. According to the report, the market expectation regarding future losses is on average 32%, which can be decomposed into a pool default rate of 40%, with 80% loss severity. Vintage and performance are key determinants.
"With structural features clearly having an impact on price sensitivity, it is now more important than ever to understand slight nuances from deal-to deal through in-depth cash flow modeling," said Richard Hrvatin, Fitch managing director and author of the report.