A Practical Guide to the Validation of Models Used to Value, Hedge and Forecast Mortgage Servicing Assets (MSAs) : Part I - Process Verification

Mortgage servicing assets are complex option-embedded financial instruments. Their values are volatile and highly exposed to interest rate risk. Much of the blame for the financial crisis of 2008 has been placed on the mortgage industry. This led to the resurrection of the risk-sharing bond concept in 2013. That is when government-sponsored enterprises (GSEs) started using credit-risk-transfer (CRT) transactions to reduce their exposure to credit risk. Mortgage put-back risk manifested itself in giant lawsuits from mortgage bond investors demanding banks to repurchase loans. Extremely low interest rates along with Federal Reserve agency MBS purchase program forced modelers to re-think their term structure models, prepayment models, primary-secondary spread (pss) models, etc. Poor performance of the prepayment models put MSR hedging strategies to the real model risk test. This paper series will examine the state of the mortgage industry and its organization while proposing a practical approach to the validation of models used to price, forecast, and hedge mortgage servicing assets. It is our hope that what is outlined in this paper will help model validators provide "effective challenge" and strengthen model risk management practices. In Part I, we will focus on the validation of inputs and processing components