CLEAN™ MBS Valuation

Coupled Lattice Efficiency Analysis(CLEAN™)

Andrew Kalotay Associates has introduced another first to the fixed income markets, its revolutionary CLEAN™ approach for valuing mortgage-backed securities (MBS) and most collateralized mortgage securities (CMOs). CLEAN™ uses a prepayment model based on the premise of "refunding efficiency." Mortgage rates and MBS rates are represented as two perfectly correlated lattices—one used to determine mortgage refinancing and the other to value the MBS. The formulation allows for recursive valuation with a resultant increase in speed and accuracy.

New and Improved Prepayment Model

As commonly recognized, prepayments dominate the valuation of MBS. Conventionally, prepayment behavior is projected using historical data. In periods of rampant financing, such as the fall of 2001, the inadequacy of a historical valuation model manifests itself. Inevitably valuation that incorporates periods of extreme prepayment volatility has given rise to a "new and improved" MBS valuation model, CLEAN™.

The CLEAN™ modeling approach categorizes mortgagors across a wide spectrum of refinancing behavior. Those who refinance with 100% efficiency, we call the financial engineers. Those refinancing too early are the leapers. Those refinancing too late are the laggards. The model also accommodates a baseline prepayment rate which is dependent on demographic factors rather than interest rates.

Efficiency Buckets

The CLEAN™ model partitions the mortgage pool into efficiency buckets and calibrates their size to explain market prices. As prepayments become known, the composition of the pool dictates the allocation of refinancing (the excess over baseline prepayments). Leapers are eliminated first, then financial engineers, and finally laggards. Consequently, as the MBS ages, its composition gradually shifts toward the laggards. This characteristic automatically accounts for burnout (slow down of prepayments following major refinancing) with no additional adjustment required.

Rigorous Option-Based Analysis

The distinguishing characteristic of the CLEAN^TM approach is the rigorous option-based analysis of individual buckets of mortgages, which requires an optionless mortgage yield curve to generate a lattice. Optionless mortgage rates, although not explicitly observable, are easily derived from market data.

Refinancing Efficiency

The model introduces a completely new model concept—refinancing efficiency based upon prepayment behavior, which in turn can be readily calibrated to market prices. The model allows for recursive valuation, a vastly superior, more accurate and tremendously faster method than conventional Monte Carlo analysis.