Wednesday, August 5, 2009

Debt analysis - Market based valuation of mortgages

When it comes to market-based valuation of mortgages, it mainly depends on what rate you discount it on, it is similar to a bond valuation, the housing market crash caused sudden slump in liquidity and increased defaults which led to increase in the mortgage rates leading to sudden decrease in the NPV of the mortgage which is basically its value.

When it comes to valuation of mortgages, the theory applies only initially, what if there is no market (liquidity) for the instrument? You cannot sit on the valuation you came to using the model you are talking about.

The ABX index does that precisely. It tells you the losses and gains the derivatives make and hence you are bound to downgrade the valuation. Simply a instrument has no value if it cannot be traded which is the case nowadays in CDO's containing tranches of sub prime debt and other defaulted debt instruments, so the CDO's are written down on the values but their values are not 0, for example if a CDO is worth 1000 dollars and the sub prime tranch is valued initially at 150 dollars, so a 50 percent write down in the value of the sub prime tranch would result in a reduction in the tranch's value to 75 dollars and the whole CDO's value to 1000 to 75 that is 925 dollars; however CDO's unlike this example contained contained greater proportion of the sub prime tranch in the current scenario which was as a result of greater risk taking in midst of plenty of liquidity in the US market and abroad.

The computer models valued the instruments in precisely the way you are talking about with certain weights on the liquidity and the kind of return and risk; however, the defaults or the risk anticipated by the computer model was far more than expected.

Banking system in India. Why banks in India are facing difficulty in getting deposits?

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