Chapter 3: Fundamentals of Investment Analysis

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Chapter 3 Fundamentals of Investment Analysis

• Andrew Davidson
• Anthony B. Sanders
• Lan-Ling Wolff
• Anne Ching

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Analytical Problems of Increasing Complexity
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Types of Investors

• Trading
• The firm seeks to buy securities for which it
  believes others in the market will be willing to
  pay a higher price.
• Net interest spread
• Net-interest investors seek to earn a steady
  stream of income based upon the difference
  between what they earn on the assets they own
  versus what they pay on liabilities they have
  incurred.
• Total return
• The total return manager seeks to outperform a
  set of benchmarks on a total return basis. Total
  return means the sum of income and changes in
  value over a specified time horizon.

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Analytical Framework
5
Methodology

• The methodology phase sets the stage for the
  analysis. In this phase, the types of risk that
  will be considered are determined.
• The methodology phase is the most important phase
  and often the most overlooked.
• The goal of this phase is to specify the range of
  influences on the securities performance that
  will be included in the analysis.
• The methodology phase is critical because it sets
  the boundaries of the analysis. Factors that are
  left out in this phase cannot be considered in
  the analysis.

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Methodology (continued)

• Due to the complexity of securitization and
  structured securities, many factors need to be
  included when analyzing these types of
  securities.
• Too often, however, methods that work for other
  instruments are blindly applied, without due
  consideration of other factors.
• For example, the performance of an MBS might be
  related to activity in the housing market, the
  performance of a commercial mortgage deal may
  depend on the strength of retail sales, or the
  performance of a credit card deal may depend on
  the level of personal bankruptcies.
• Failure to assess the impact of changing economic
  conditions might result in overlooking a
  potential risk of the investment.
• The primary component of the economic environment
  that affects most fixed income investments is
  interest rates.

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Methodology (continued)

• For non-callable high quality securities, the
  interest rate environment determines the value
  and risk of the investment in a relatively
  straightforward manner.
• For callable securities, such as MBS and other
  structured products, interest rates affect these
  securities through the interaction of potential
  changes in interest rates with the potential
  changes in the securities
• cash flow. Determining value and risk is a more
  complex process.
• A wide range of interest-rate assumptions are
  possible
• Interest-rate assumptions can vary from the
  simple, where interest rates are expected to
  remain constant at their current levels
• to dynamic, where, for example, interest rates
  change linearly over the next twelve months, each
  move having a probability given by the current
  volatility of interest rates to the
  sophisticated, where interest rates are generated
  by a two-factor log-normal mean-reverting
  process, which satisfies a no-arbitrage condition
  and whose variances and covariance are consistent
  with historical observation.

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Methodology (continued)

• Interest rates are not the only factors that
  affect performance of securities.
• As warm-blooded securities, the value and
  performance of these complex instruments are
  influenced by whatever factors affect the
  borrowers.
• Changes in an individuals family (marriage,
  divorce, children, death) will affect the
  homeownership and creditworthiness of the
  borrower.
• As securitizations represent many different
  individual borrowers, the decisions of any one
  borrower will not have a significant impact on
  investors.
• Taken together, the behavior of individuals will
  determine the performance of the securities.
• For this reason, securities analysts look to
  economic data on employment and housing markets
  as well as other economic and demographic data.
• One of the major complexities of this process is
  that these soft features of collateral and
  security performance must be viewed in the
  context of the interest-rate assumptions.
• It is not enough to determine that rising
  unemployment tends to slow prepayment levels. It
  is also necessary to determine how much
  unemployment will rise or fall as interest rates
  change.

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Collateral Performance

• Based upon the choice of approach and the
  associated assumptions about the economic
  environment, investors can evaluate the
  characteristics and expected performance of the
  collateral.
• The goal of the analysis is to produce
  assumptions that can be used in determining the
  cashflows of the collateral and the securities.
• The assumptions are generally either in the form
  of a single number applied to a measure of
  performance, like an annual rate, or in the form
  of a model which relates inputs about the
  collateral and the economic environment to month
  by month forecasts of performance.
• The focus of this analysis is usually on
  prepayments and credit.

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Collateral Performance (continued)

• Prepayments represent the options of borrowers to
  prepay loans.
• Many products allow prepayment at any time some
  have prepayment penalties or other contractual
  features that may limit prepayments.
• Unlike corporate bonds, prepayments on consumer
  assets are determined primarily based on analysis
  of historical data, rather than principles of
  optimal exercise because borrowers face unseen
  costs that are difficult to assess directly.

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Collateral Performance (continued)

• Credit evaluation is primarily an evaluation of
  the potential for delinquency and default, and
  the associated severity of loss.
• Generally, loans that miss a payment are
  considered delinquent.
• Delinquency is measured in number of days
  payments are overdue.
• Delinquencies in excess of 60 or 90 days are
  considered seriously delinquent.
• For some products, delinquencies of this
  magnitude are considered defaults.
• Default represents the beginning of the recovery
  process. A servicer may attempt to recover losses
  on non-paying loans through renegotiations or
  foreclosure.
• The difference between the loan balance and any
  recoveries less expenses is the severity of the
  loss.

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Collateral Performance (continued)

• Prepayments and credit assumptions are usually
  created via analysis of historical data.
• The development and evaluation of these
  assumptions is a central part of developing
  structures for securitization and valuing the
  resulting securities.
• Each type of collateral requires an in-depth
  analysis of its performance characteristics.

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Structure

• The structure phase is the core of the analytical
  process. In this phase, the cash flows of the
  securities are calculated based upon the
  environmental assumptions of the methodology
  phase, the assumptions generated in the
  performance phase, and the legal and contractual
  features of the collateral and the
  securitization.
• The results generated in the next phase generally
  are attempts to summarize the characteristics of
  the cashflows in useful ways.
• Calculation of the cash flow is theoretically the
  most straightforward phase, but for many
  applications it is the most time consuming.

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Structure (continued)

• The calculation procedure starts with the most
  basic component, the underlying collateral, and
  then derives the cash flows of the securities
  backed by those loans.
• Pass-though securities are calculated based on
  the loan cash flows.
• Structured securities cash flows are based on the
  pass-through cash flows.
• Portfolio cash flows are calculated based on the
  cash flows of the securities.
• The process of splitting the cash flows from the
  collateral into various securities is sometimes
  called the waterfall, as it describes how cash
  flows are divided between various instruments.

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Structure (continued)

• The greatest complexity in this phase is
  gathering the appropriate indicative data that
  describe the securities.
• Each loan has unique characteristics that
  determine its cash flows and each security may be
  governed by a complex set of rules that determine
  how the incoming cash is split between several
  different securities.
• Another important consideration in this phase is
  determining the appropriate level of detail for
  the analysis.
• In some cases, loan-by-loan information is not
  available, so the analysis must be based on
  weighted average characteristics. In other cases,
  more information may be available.
• The analyst must then determine the tradeoff
  between additional accuracy and computational
  efficiency.

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Results

• The final phase of the analysis is the results
  phase.
• Based on the calculated cashflows, and the
  theoretical framework of the methodology, summary
  measures are produced in the results phase.
• The purpose of these measures is to aid in the
  investment process. These analytical results
  generally provide insight into income, valuation
  and risk.
• Income measures provide insight into the pattern
  of future cashflows and the levels of income.

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Results (continued)

• Valuation measures provide guidance in
  identifying rich and cheap securities.
• While better measures provide more reliable
  indicators of future performance, all existing
  measures have both strengths and weaknesses.
• Risk measures provide guidance in assessing the
  range of outcomes for an investment, as well as
  how a particular investment will perform relative
  to other securities.

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Types of Analytical Results