Thanks to Team MIAC and Rob Branthover for submitting this.

OTTI, It’s all about expected collateral behavior…
January 22nd, 2009.

Other-Than-Temporary Impairment (“OTTI”) has been a topic of great concern in the current market environment for many holders of distressed MBS securities. Some of these securities are highly illiquid and have lost significant market value in the current displaced market. Financial institutions that hold these securities are required to evaluate if the loss in fair market value is other-than-temporary and take charges to the extent the loss in fair market value is related to credit loss and it is other-than-temporary. The OTTI could create additional pressure for financial institutions that continue to struggle to maintain their regulatory capital requirements.

On December 19th, FASB proposed changes to OTTI guidance that could reduce the amount of impairment charges banks and other holders of mortgage backed securities have to report. On January 7th, the FASB voted 3-2 to adopt FSP EITF 99-20-a and these changes became effective Q408 reporting. Previous guidance required to measure OTTI based on cashflows projection that was used by market participants in determining the fair value of the mortgage backed securities. The current market is very illiquid and many of these securities are reflecting a distressed market exit price. A permissible pre-EITF 99-20-a interpretation would be to utilize the distressed market MBS pricing to calibrate implied prospective collateral behavior assumptions. Just as the SEC staff issued a clarifying guidance (“FSP FAS 157-3”) acknowledging that the current MBS pricing reflects distressed market conditions and could, therefore, be ignored, FSP EITF 99-20-a allows financial reporters to make realistic and defendable collateral behavior assumptions for OTTI, but they don’t necessarily have to calibrate back to distressed market price. The calibration process involves deriving the implied foreclosure loss frequency and severity implied for a particular price, yield and voluntary prepayment assumptions.

The new guidance allows the banks and holders of impaired mortgage backed securities to use all the available information reflecting past events and current condition when modeling the projected cashflows for OTTI measurement. All available information would include, but not be limited to, the remaining payment terms of the instrument and economic factors that are relevant to the collectibility of the instrument, such as current prepayment speeds, the current financial condition of the issuer(s), and the value of any underlying real estate collateral.

- Most importantly in this current environment, the user models must include the recognition of the significant impact the declining residential real estate market has on voluntary prepayment projections.

Just as FSP EITF 99-20-a makes the methodology consistent with FAS157-3, MIAC also embraces this consistency. MIAC pricing process is broken down into two component parts - market consensus collateral behavior assumptions that drive the assets anticipated cash flows and the valuing or discounting of the asset’s cash flows using a discount rate that reflect an appropriate and benchmark calibrated risk premium. In establishing a discount rate to be used, MIAC accesses many different variables associated with each bond including but not limited to its weighted-average life, duration, convexity, credit enhancement level, historical deal performance, current coverage ratio, rating agency current ratings, type of bond and liquidity for the bond in the current market place. Dealers spread reports, actual trade pricing information or proprietary yield derivation methods could be used to determine the appropriate discount rate to be applied to each bond in determining its fair value that reflect how each bond could trade in an orderly market place.

MIAC’s formal process for capturing collateral behavior assumptions encompasses all the elements of the new OTTI guidance.  Our loan default methodology utilizes a roll-rate model to estimate the amount of future defaults, losses and the timing of those losses to impact the deal capital structure. This default methodology takes into account the current, delinquent and seriously delinquent status of the loan and appropriately models an expected probability of that loan to enter into default and subsequently liquidate.

MIAC’s consensus collateral behavior opinion is a result of extensive research including having gathered and analyzed historical loan-level performance data and a collection of mortgage industry research on expected mortgage loan collateral behavior from various Wall Street participants. Roll rate assumptions for loans in any current, delinquent or seriously delinquent status to enter into default have been appropriately modeled into the collateral cash flow projection according to loan classification and vintage. Once a loan enters the foreclosure process, state-level foreclosure time-lines are used to estimate the expected number of months a loan will remain in foreclosure until it enters REO (real-estate owned) status and is subsequently liquidated. When an Attorney General announces yet another 90 Day moratorium on FCLs, MIAC will reflect this in our state level time in FCL assumptions. Additionally, an expected average remaining months in foreclosure and REO are applied to loans which are already in foreclosure and REO status. Once a loan enters into REO status, an expected time frame to liquidation is applied according to servicer current REO liquidation experience.

MIAC has developed consensus loss severity assumptions that are applied to loans according to collateral type and vintage. MIAC’s loss severity assumptions have been developed as a result of extensive research including having gathered and analyzed historical loan-level performance data and a collection of mortgage industry research on expected mortgage loan loss severity from various Wall Street participants. Mortgage loan characteristics considered when determining the appropriate loss severity to be applied include (but are not limited to) loan type, loan size, lien type, loan age, loan-to-value, state, metropolitan statistical area and the rate of home price appreciation or depreciation as reported by widely recognized home price indices data providers.

New OTTI guidance still requires banks and holders of mortgage backed securities to evaluate whether the significant loss in fair market value of their MBS is other-than-temporary. An entity should not automatically conclude that any impairment is not other-than-temporary just because all of the scheduled payment till to date have been received.

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