DTCC Will Strengthen Risk Management For Mortgage-Backed Securities
In early 2008, DTCC’s Fixed Income Clearing Corporation (FICC) will implement a more rigorous risk management model for the calculation of Participant Fund obligations of participants in its Mortgage-Backed Securities Division (MBSD). A key component of the new approach will be use of a Value at Risk (VaR) method-ology to calculate the amount of collateral firms must post with FICC to cover potential losses incurred as a result of a default by a participant.
FICC is awaiting approval of its filing (SR-FICC-2007-10) in this regard with the Securities and Exchange Commission (SEC).
In addition to improving risk management processes for customer-related activity in the MBSD, the change will further standardize DTCC’s risk management methodologies across its clearing subsidiaries. A VaR methodology is already used by FICC’s Government Securities Division (GSD) and DTCC’s National Securities Clearing Corporation subsidiary.
Measuring portfolio risk
“The new methodology will enable us to measure the portfolio risk of our mortgage-backed customers more effectively, which is a key variable in calculating Participant Fund requirements,” said Douglas George, DTCC’s chief risk officer. “The change will ensure FICC has sufficient collateral to facilitate orderly settlement if we are obliged to close out an insolvent participant’s positions – and that translates into stronger risk management for FICC, its MBS customers and the mortgage-backed market overall.”
What’s more, VaR is a critical stepping stone for implementation of the central counterparty (CCP) that FICC is building for its mortgage-backed business. Set to launch in late 2008, the new CCP will provide a guarantee of settlement of transactions netted by the MBSD.
Safety and soundness
“The new risk model will bring greater safety and soundness to the mortgage-backed market,” said Murray Pozmanter, DTCC managing director, Clearance and Settlement Product Management. “The turmoil in credit markets over the past several months clearly underscores the value of bringing more stringent risk management to our mortgage-backed business,” he added, noting that a critical part of DTCC’s role in the industry is to risk-manage the financial exposure of member firms.
On the aggregate level, the average daily Participant Fund requirement for MBS customers was $2.7 billion for the first half of 2007. Initially, the new risk model will result in higher requirements for some firms, depending on their portfolio and business. However, increases are expected to be temporary in most cases.
It is anticipated that relief may come in the form of lower collateral requirements as a result of common margining proposed for common members of the GSD and MBSD, expected by late 2008. “Once FICC introduces common margining, most customers will see a material reduction in their overall funding contribution because they will be able to apply the collateral held in one division against requirements in the other,” Pozmanter said. “Common margining will be part of the MBS CCP implementation.”
VaR’s value
VaR, a widely recognized tool in financial services, is both broader and more sophisticated than the methodology currently used to calculate Participant Fund requirements for FICC’s mortgage-backed customers, according to Jiping Guo, DTCC vice president, Risk Management.
“VaR measures the uncertainty of market volatility for any given portfolio,” said Guo. “In its simplest form, it provides an estimate of the portfolio’s possible losses based on a given confidence level over a particular time horizon.”
VaR measures three key variables:
- Market volatility. This factor drives gains and losses for a given portfolio, and is the most challenging part of a VaR model.
- Time horizon. This refers to the period of time required to close out a portfolio.
- Confidence level. This factor determines in percentage terms how much protection a firm requires. For example, if a 99% three-day VaR is $10 million, it means that the maximum expected loss during a three-day period is below $10 million 99% of the time.
For mortgage-backed securities, VaR calculations must factor in other complexities that require intensive computer simulations, according to Guo. “The most challenging piece of the equation is calculating the market volatility of the TBA [to-be-announced] securities processed by our MBS division,” he said. “To accurately price these securities, we have to project a series of complex, overlapping variables.” These include interest rates, mortgage rates, prepayment speeds, seasonality in the housing market (activity peaks in the summer and declines in the winter), interest rate refinancings, a portfolio’s diversification and hedging.
To address these issues, DTCC’s Risk Management group is building a highly sophisticated pricing engine that will have the capacity to calculate key variables that impact portfolio valuation. In addition, the VaR model will use a three-day liquidation period, instead of the current one day, and a confidence level of 99%, which is the industry standard. “If we need to close out a customer’s portfolio, three days will ensure FICC has sufficient time to liquidate outstanding positions and 99% will provide ample protection against potential losses,” said George.
Noting that FICC’s Government Securities Division implemented a 99% three-day VaR in January 2007, Pozmanter added, “Having the same time horizon and confidence factor for FICC’s government and mortgage-backed divisions is a pre-condition for the implementation of common margin requirements.”
Getting the word out
FICC has contacted all customers that will be affected by the upcoming changes, explaining the new methodology and providing projections for the likely impact on their collateral requirements. “We have talked to all our customers about the expected changes in their numbers, we have sent a VaR primer to all firms and we will be conducting informational seminars to answer questions and address concerns,” said Pozmanter. Despite the possibility of higher margin requirements over the short term, the response from firms has been generally positive.
“Given the recent market instability, customers fully understand and support our efforts to strengthen risk management in our mortgage-backed business,” said Pozmanter. @
[To learn more about the new risk methodology for FICC’s MBSD, contact Jiping Guo, DTCC
vice president, Risk Management, at jguo@dtcc.com or 212.855.5755, or Elke Jakubowski, DTCC vice president, Clearance and Settlement Product Management, at 212.855.7581 or ejakubowski@dtcc.com.]