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Fed MBS Runoff Portends More Negative Vega for the Broader Market

With much anticipation and fanfare, the Federal Reserve is finally on track to reduce its MBS holdings. Guidance from the September FOMC meeting reveals that the Fed will allow its MBS holdings to “run off,” reducing its position via prepayments as opposed to selling it off. What does this Fed MBS Runoff mean for the market? In the long-term, it means a large increase in net supply of Agency MBS and with it an increase in overall implied and realized volatility.

 

MBS: The Largest Net Source of Options in the Fixed-Income Market

We start this analysis with some basic background on the U.S. MBS market. U.S. homeowners, by in large, finance home purchases using fixed-rate 30-year mortgages. These fixed-rate mortgages amortize over time, allowing the homeowner to pay principal and interest in even, monthly payments. A homeowner has the option to pay off this mortgage early for any reason, which they tend to do when either the homeowner moves, often referred to as turnover, or when prevailing mortgage rates drop significantly below the homeowner’s current mortgage rate, referred to as refinancing or “refis.” As a rough rule-of-thumb, turnover has varied between 6% and 10% per annum as economic conditions vary, whereas refis can drive prepayments to 40% per annum under current lending conditions.[1] Rate refis account for most of a mortgage’s cash flow volatility.

If the homeowner is long the option to refinance, the MBS holder is short that same option. Fixed-rate MBS shorten due to prepayments as rates drop, and extend as rates rise, putting the MBS holder into a short convexity (gamma) and short vega position. Some MBS holders hedge this risk explicitly, buying short- and longer-dated options to cover their short gamma/short vega risk. Others hedge dynamically, including money managers and long-only funds that tend to target a duration bogey. One way or another, the short-volatility risk from MBS is transmitted into the larger fixed-income market. Hence, the rates market is net short vol risk.

While not all investors hedge their short-volatility position, the aggregate market tends to hedge a similar amount of the short-options position over time. Until, of course, the Fed, the largest buyer of MBS, entered the market. From the start of Quantitative Easing, the Fed purchased progressively more of the MBS market, until by the end of 2014 the Fed just under 30% of the agency MBS market. Over the course of five years, the effective size of the MBS market ex-Fed shrunk by more than a quarter. Since the Fed doesn’t hedge its position, either explicitly through options or implicitly through delta-hedging, the size of the market’s net-short volatility position dropped by a similar fraction.[2]

The Fed’s Balance Sheet

As of early October 2017, the Federal Reserve owned $1.77 trillion agency MBS, or just under 30% of the outstanding agency MBS market. The Fed publishes its holdings weekly which can be found on the New York Fed’s web site here. In the chart below, we summarize the Fed’s 30yr MBS holdings, which make up roughly 90% of the Fed’s MBS holdings. [3]

Runoff from the Fed

Following its September meeting, the Fed announced they will reduce their balance sheet by not reinvesting run-off from their treasury and MBS portfolio. If the Fed sticks to its plan, MBS monthly runoff from MBS will reach $20B by 2018 Q1.

Assuming no growth in the aggregate mortgage market, runoff from these MBS will be replaced with the same size of new, at-the-money MBS passthroughs. Since the Fed is not reinvesting paydowns, these new passthroughs will re-enter the non-Fed-held MBS market, which does hedge volatility by either buying options or delta-hedging.

Given the expected runoff rate of the Fed’s portfolio, we can now estimate the vega exposure of new mortgages entering the wider (non-Fed-held) market. When fully implemented, we estimate that $20B in new MBS represents roughly $34 million in vega hitting the market each month. To put that in perspective, that is roughly equivalent to $23 billion notional 3yr->5yr ATM swaption straddles hitting the market each and every month.

 

Conclusion

While the Fed isn’t selling its MBS holdings, portfolio runoff will have a significant impact on rate volatility. Runoff implies significant net issuance ex-Fed. It’s reasonable to expect increased demand for options hedging, as well as increased delta-hedging, which should drive both implied and realized vol higher over time. This change will manifest itself slowly as monthly prepayments shrinks the Fed’s position. But the reintroduction of negative vega into the wider market represents a change in paradigm which may lead to a more volatile rates market over time.

 


[1] In the early 2000s, prepayments hit their all-time highs with the aggregate market prepaying in excess of 60% per annum.

[2] This is not entirely accurate. The short-vol position in a mortgage passthrough is also a function of its note rate (GWAC) with respect to the prevailing market rate, and the mortgage market has a distribution of note rates. But the statement is broadly true.

[3] The remaining Fed holdings are primarily 15yr MBS pass-throughs.


What is an “S-Curve” and Does it Matter if it Varies by Servicer?

Mortgage analysts refer to graphs plotting prepayment rates against the interest rate incentive for refinancing as “S-curves” because the resulting curve typically (vaguely) resembles an “S.” The curve takes this shape because prepayment rates vary positively with refinance incentive, but not linearly. Very few borrowers refinance without an interest rate incentive for doing so. Consequently, on the left-hand side of the graph, where the refinance incentive is negative or out of the money, prepayment speeds are both low and fairly flat. This is because a borrower with a rate 1.0% lower than market rates is not very much more likely to refinance than a borrower with a rate 1.5% lower. They are both roughly equally unlikely to do so.

As the refinance incentive crosses over into the money (i.e., when prevailing interest rates fall below rates the borrowers are currently paying), the prepayment rate spikes upward, as a significant number of borrowers take advantage of the opportunity to refinance. But this spike is short-lived. Once the refinance incentive gets above 1.0% or so, prepayment rates begin to flatten out again. This reflects a segment of borrowers that do not refinance even when they have an interest rate incentive to do so. Some of these borrowers have credit or other issues preventing them from refinancing. Others are simply disinclined to go through the trouble. In either case, the growing refinance incentive has little impact and the prepayment rate flattens out.

These two bends—moving from non-incentivized borrowers to incentivized borrowers and then from incentivized borrowers to borrowers who can’t or choose not to refinance—are what gives the S-curve its distinctive shape.

Figure 1: S-Curve Example

An S-Curve Example – Servicer Effects

Interestingly, the shape of a deal’s S-curve tends to vary depending on who is servicing the deal. Many things contribute to this difference, including how actively servicers market refinance opportunities. How important is it to be able to evaluate and analyze the S-curves for the servicers specific to a given deal? It depends, but it could be imperative.

In this example, we’ll analyze a subset of the collateral (“Group 4”) supporting a recently issued Fannie Mae deal, FNR 2017-11. This collateral consists of four Fannie multi-issuer pools of recently originated jumbo-conforming loans with a current weighted average coupon (WAC) of 3.575% and a weighted average maturity (WAM) of 348 months. The table below shows the breakout of the top six servicers in these four pools based on the combined balance.

Figure 2: Breakout of Top Six Servicers

Over half (54%) of the Group 4 collateral is serviced by these six servicers. To begin the analysis, we pulled all jumbo-conforming, 30-year loans originated between 2015 and 2017 for the six servicers and bucketed them based on their refi incentive. A longer timeframe is used to ensure that there are sufficient observations at each point. The graph below shows the prepayment rate relative to the refi incentive for each of the servicers as well as the universe.

Figure 3: S-curve by Servicer

For loans that are at the money—i.e., the point at which the S-curve would be expected to begin spiking upward—only those serviced by IMPAC prepay materially faster than the entire cohort. However, as the refi incentive increases, IMPAC, Seneca Mortgage, and New American Funding all experience a sharp pick-up in speeds while loans serviced by Pingora, Lakeview, and Wells behave comparable to the market.

The last step is to compute the weighted average S-curve for the top six servicers using the current UPB percentages as the weights, shown in Figure 4 below. On the basis of the individual servicer observations, prepays for out-of-the-money loans should mirror the universe, but as loans become more re-financeable, speeds should accelerate faster than the universe. The difference between the six-servicer average and the universe reaches a peak of approximately 4% CPR between 50 bps and 100 bps in the money. This is valuable information for framing expectations for future prepayment rates. Analysts can calibrate prepayment models (or their outputs) to account for observed differences in CPRs that may be attributable to the servicer, rather than loan characteristics.

Figure 4: Weighted Average vs. Universe

This analysis was generated using RiskSpan’s data and analytics platform, RS Edge.


Validating Interest Rate Models

Many model validations—particularly validations of market risk models, ALM models, and mortgage servicing rights valuation models—require validators to evaluate an array of sub-models. These almost always include at least one interest rate model, which are designed to predict the movement of interest rates.

Validating interest rate models (i.e. short-rate models) can be challenging because many different ways of modeling how interest rates change over time (“interest rate dynamics”) have been created over the years. Each approach has advantages and shortcomings, and it is critical to distinguish the limitations and advantages of each of them  to understand whether the short-rate model being used is appropriate to the task. This can be accomplished via the basic tenets of model validation—evaluation of conceptual soundness, replication, benchmarking, and outcomes analysis. Applying these concepts to interest rate models, however, poses some unique complications.

A brief Introduction to the Short-Rate Model

In general, a short-rate model solves the short-rate evolution as a stochastic differential equation. Short-rate models can be categorized based on their interest rate dynamics.

A one-factor short-rate model has only one diffusion term. The biggest limitation of one-factor models is that the correlation between two continuously-compound spot rates at two dates is equal to one, which means a shock at a certain maturity is transmitted thoroughly across the curve that is not realistic in the market.

A multi-factor short-rate model, as its name implies, contains more than one diffusion term. Unlike one-factor models, multi-factor models consider the correlation between forward rates, which makes a multi-factor model more realistic and consistent with actual multi-dimension yield curve movements.

Validating Conceptual Soundness

Validating an interest rate model’s conceptual soundness includes reviewing its data inputs, mean-reversion feature, distributions of short rate, and model selection. Reviewing these items sufficiently requires a validator to possess a basic knowledge of stochastic calculus and stochastic differential equations.

Data Inputs

The fundamental data inputs to the interest rate model could be the zero-coupon curve (also known as term structure of interest rates) or the historical spot rates. Let’s take the Hull-White (H-W) one-factor model (H-W: drt = k(θ – rt)dt + σtdwt) as an example. H-W is an affine term structure model, of which analytical tractability is one of its most favorable properties. Analytical tractability is a valuable feature to model validators because it enables calculations to be replicated. We can calibrate the level parameter (θ) and the rate parameter (k) from the inputs curve. Commonly, the volatility parameter (σt) can be calibrated from historical data or swaptions volatilities. In addition, the analytical formulas are also available for zero-coupon bonds, caps/floors, and European swaptions.

Mean Reversion

Given the nature of mean reversion, both the level parameter and rate parameter should be positive. Therefore, an appropriate calibration method should be selected accordingly. Note the common approaches for the one-factor model—least square estimation and maximum likelihood estimation—could generate negative results, which are unacceptable by the mean-reversion feature. The model validator should compare different calibration results from different methods to see which method is the best approach for addressing the model assumption.

Short-Rate Distribution and Model Selection

The distribution of the short rate is another feature that we need to consider when we validate the short-rate model assumptions. The original short-rate models—Vasicek and H-W, for example—presume the short rate to be normally distributed, allowing for the possibility of negative rates. Because negative rates were not expected to be seen in the simulated term structures, the Cox-Ingersoll-Ross model (CIR, non-central chi-squared distributed) and Black-Karasinski model (BK, lognormal distributed) were invented to preclude the existence of negative rates. Compared to the normally distributed models, the non-normally distributed models forfeit a certain degree of analytical tractability, which makes validating them less straightforward. In recent years, as negative rates became a reality in the market, the shifted lognormal distributed model was introduced. This model is dependent on the shift size, determining a lower limit in the simulation process. Note there is no analytical formula for the shift size. Ideally, the shift size should be equal to the absolute value of the minimum negative rate in the historical data. However, not every country experienced negative interest rates, and therefore, the shift size is generally determined by the user’s experience by means of fundamental analysis.

The model validator should develop a method to quantify the risk from any analytical judgement. Because the interest rate model often serves as a sub-model in a larger module, the model selection should also be commensurate with the module’s ultimate objectives.

Replication

Effective model validation frequently relies on a replication exercise to determine whether a model follows the building procedures stated in its documentation. In general, the model documentation provides the estimation method and assorted data inputs. The model validator could consider recalibrating the parameters from the provided interest rate curve and volatility structures. This process helps the model validator better understand the model, its limitations, and potential problems.

Ongoing Monitoring & Benchmarking

Interest rate models are generally used to simulate term structures in order to price caps/floors and swaptions and measure the hedge cost. Let’s again take the H-W model as an example. Two standard simulation methods are available for the H-W model: 1) Monte Carlo simulation and 2) trinomial lattice method. The model validator could use these two methods to perform benchmarking analysis against one another.

The Monte Carlo simulation works ideally for the path-dependent interest rate derivatives. The Monte Carlo method is mathematically easy to understand and convenient for implementation. At each time step, a random variable is simulated and added into the interest rate dynamics. A Monte Carlo simulation is usually considered for products that can only be exercised at maturity. Since the Monte Carlo method simulates the future rates, we cannot be sure at which time the rate or the value of an option becomes optimal. Hence, a standard Monte Carlo approach cannot be used for derivatives with early-exercise capability.

On the other hand, we can price early-exercise products by means of the trinomial lattice method. The trinomial lattice method constructs a trinomial tree under the risk-neutral measure, in which the value at each node can be computed. Given the tree’s backward-looking feature, at each node we can compare the intrinsic value (current value) with the backwardly inducted value (continuous value), determining whether to exercise at a given node. The comparison step will keep running backwardly until it reaches the initial node and returns the final estimated value. Therefore, trinomial lattice works ideally for non-path-dependent interest rate derivatives. Nevertheless, lattice can be also implemented for path-dependent derivatives for the purpose of benchmarking.

Normally, we would expect to see that the simulated result from the lattice method is less accurate and more volatile than the result from the Monte Carlo simulation method, because a larger number of simulated paths can be selected in the Monte Carlo method. This will make the simulated result more stable, assuming the same computing cost and the same time step.

Outcomes Analysis

The most straightforward method for outcomes analysis is to perform sensitivity tests on the model’s key drivers. A standardized one-factor short-rate model usually contains three parameters. For the level parameter (θ), we can calibrate the equilibrium rate-level from the simulated term structure and compare with θ. For the mean-reversion speed parameter (k), we can examine the half-life, which equals to ln ⁡(2)/k , and compare with the realized half-life from simulated term structure. For the volatility parameter (σt), we would expect to see the larger volatility yields a larger spread in the simulated term structure. We can also recalibrate the volatility surface from the simulated term structure to examine if the number of simulated paths is sufficient to capture the volatility assumption.

As mentioned above, an affine term structure model is analytically tractable, which means we can use the analytical formula to price zero-coupon bonds and other interest rate derivatives. We can compare the model results with the market prices, which can also verify the functionality of the given short-rate model.

Conclusion

The popularity of certain types of interest rate models changes as fast as the economy. In order to keep up, it is important to build a wide range of knowledge and continue learning new perspectives. Validation processes that follow the guidelines set forth in the OCC’s and FRB’s Supervisory Guidance on Model Risk Management (OCC 2011-12 and SR 11-7) seek to answer questions about the model’s conceptual soundness, development, process, implementation, and outcomes.  While the details of the actual validation process vary from bank to bank and from model to model, an interest rate model validation should seek to address these matters by asking the following questions:

  • Are the data inputs consistent with the assumptions of the given short-rate model?
  • What distribution does the interest rate dynamics imply for the short-rate model?
  • What kind of estimation method is applied in the model?
  • Is the model analytically tractable? Are there explicit analytical formulas for zero-coupon bond or bond-option from the model?
  • Is the model suitable for the Monte Carlo simulation or the lattice method?
  • Can we recalibrate the model parameters from the simulated term structures?
  • Does the model address the needs of its users?

These are the fundamental questions that we need to think about when we are trying to validate any interest rate model. Combining these with additional questions specific to the individual rate dynamics in use will yield a robust validation analysis that will satisfy both internal and regulatory demands.


AML Model Validation: Effective Process Verification Requires Thorough Documentation

Increasing regulatory scrutiny due to the catastrophic risk associated with anti-money-laundering (AML) non-compliance is prompting many banks to tighten up their approach to AML model validation. Because AML applications would be better classified as highly specialized, complex systems of algorithms and business rules than as “models,” applying model validation techniques to them presents some unique challenges that make documentation especially important.

In addition to devising effective challenges to determine the “conceptual soundness” of an AML system and whether its approach is defensible, validators must determine the extent to which various rules are firing precisely as designed. Rather than commenting on the general reasonableness of outputs based on back-testing and sensitivity analysis, validators must rely more heavily on a form of process verification that requires precise documentation.

Vendor Documentation of Transaction Monitoring Systems

Above-the-line and below-the-line testing—the backbone of most AML transaction monitoring testing—amounts to a process verification/replication exercise. For any model replication exercise to return meaningful results, the underlying model must be meticulously documented. If not, validators are left to guess at how to fill in the blanks. For some models, guessing can be an effective workaround. But it seldom works well when it comes to a transaction monitoring system and its underlying rules. Absent documentation that describes exactly what rules are supposed to do, and when they are supposed to fire, effective replication becomes nearly impossible.

Anyone who has validated an AML transaction monitoring system knows that they come with a truckload of documentation. Vendor documentation is often quite thorough and does a reasonable job of laying out the solution’s approach to assessing transaction data and generating alerts. Vendor documentation typically explains how relevant transactions are identified, what suspicious activity each rule is seeking to detect, and (usually) a reasonably detailed description of the algorithms and logic each rule applies.

This information provided by the vendor is valuable and critical to a validator’s ability to understand how the solution is intended to work. But because so much more is going on than what can reasonably be captured in vendor documentation, it alone provides insufficient information to devise above-the-line and below-the-line testing that will yield worthwhile results.

Why An AML Solution’s Vendor Documentation is Not Enough

Every model validator knows that model owners must supplement vendor-supplied documentation with their own. This is especially true with AML solutions, in which individual user settings—thresholds, triggers, look-back periods, white lists, and learning algorithms—are arguably more crucial to the solution’s overall performance than the rules themselves.

Comprehensive model owner documentation helps validators (and regulatory supervisors) understand not only that AML rules designed to flag suspicious activity are firing correctly, but also that each rule is sufficiently understood by those who use the solution. It also provides the basis for a validator’s testing that rules are calibrated reasonably. Testing these calibrations is analogous to validating the inputs and assumptions of a predictive model. If they are not explicitly spelled out, then they cannot be evaluated.

Here are some examples.

Transaction Input Transformations

Details about how transaction data streams are mapped, transformed, and integrated into the AML system’s database vary by institution and cannot reasonably be described in generic vendor documentation. Consequently, owner documentation needs to fully describe this. To pass model validation muster, the documentation should also describe the review process for input data and field mapping, along with all steps taken to correct inaccuracies or inconsistencies as they are discovered.

Mapping and importing AML transaction data is sometimes an inexact science. To mitigate risks associated with missing fields and customer attributes, risk-based parameters must be established and adequately documented. This documentation enables validators who test the import function to go into the analysis with both eyes open. Validators must be able to understand the circumstances under which proxy data is used in order to make sound judgments about the reasonableness and effectiveness of established proxy parameters and how well they are being adhered to. Ideally, documentation pertaining to transaction input transformation should describe the data validations that are performed and define any error messages that the system might generate.

Risk Scoring Methodologies and Related Monitoring

Specific methodologies used to risk score customers and countries and assign them to various lists (e.g., white, gray, or black lists) also vary enough by institution that vendor documentation cannot be expected to capture them. Processes and standards employed in creating and maintaining these lists must be documented. This documentation should include how customers and countries get on these lists to begin with, how frequently they are monitored once they are on a list, what form that monitoring takes, the circumstances under which they can move between lists, and how these circumstances are ascertained. These details are often known and usually coded (to some degree) in BSA department procedures. This is not sufficient. They should be incorporated in the AML solution’s model documentation and include data sources and a log capturing the history of customers and countries moving to and from the various risk ratings and lists.

Output Overrides

Management overrides are more prevalent with AML solutions than with most models. This is by design. AML solutions are intended to flag suspicious transactions for review, not to make a final judgment about them. That job is left to BSA department analysts. Too often, important metrics about the work of these analysts are not used to their full potential. Regular analysis of these overrides should be performed and documented so that validators can evaluate AML system performance and the justification underlying any tuning decisions based on the frequency and types of overrides.

Successful AML model validations require rule replication, and incompletely documented rules simply cannot be replicated. Transaction monitoring is a complicated, data-intensive process, and getting everything down on paper can be daunting, but AML “model” owners can take stock of where they stand by asking themselves the following questions:

  1. Are my transaction monitoring rules documented thoroughly enough for a qualified third-party validator to replicate them? (Have I included all systematic overrides, such as white lists and learning algorithms?)
  2. Does my documentation give a comprehensive description of how each scenario is intended to work?
  3. Are thresholds adequately defined?
  4. Are the data and parameters required for flagging suspicious transactions described well enough to be replicated?

If the answer to all these questions is yes, then AML solution owners can move into the model validation process reasonably confident that the state of their documentation will not be a hindrance to the AML model validation process.


Machine Learning and Portfolio Performance Analysis

Attribution analysis of portfolios typically aims to discover the impact that a portfolio manager’s investment choices and strategies had on overall profitability. They can help determine whether success was the result of an educated choice or simply good luck. Usually a benchmark is chosen and the portfolio’s performance is assessed relative to it.

This post, however, considers the question of whether a non-referential assessment is possible. That is, can we deconstruct and assess a portfolio’s performance without employing a benchmark? Such an analysis would require access to historical return as well as the portfolio’s weights and perhaps the volatility of interest rates, if some of the components exhibit a dependence on them. This list of required variables is by no means exhaustive.

There are two prevalent approaches to attribution analysis—one based on factor models and the other on return decomposition. The factor model approach considers the equities in a portfolio at a single point in time and attributes performance to various macro- and micro-economic factors prevalent at that time. The effects of these factors are aggregated at the portfolio level and a qualitative assessment is done. Return decomposition, on the other hand, explores the manner in which positive portfolio returns are achieved across time. The principal drivers of performance are separated and further analyzed. In addition to a year’s worth of time series data for the variables listed in the previous paragraph, covariance, correlation, and cluster analyses and other mathematical methods would likely be required.

Normality Assumption

Is the normality assumption for stock returns fully justified? Are sample means and variances good proxies for population means and variances? This assumption is worth testing because Normality and the Central Limit Theorem are widely assumed when dealing with financial data. The Delta-Normal Value at Risk (VaR) method, which is widely used to compute portfolio VaR, assumes that stock returns and allied risk factors are normally distributed. Normality is also implicitly assumed in financial literature. Consider the distribution of S&P returns from May 1980 to May 2017 displayed in Figure 1.

Figure One: Distribution of S&P Returns

Panel (a) is a histogram of S&P daily returns from January 2001 to January 2017. The red curve is a Gaussian fit. Panel (b) shows the same data on a semi-log plot (logarithmic Y axis). The semi-log plot emphasizes the tail events.

The returns displayed in the left panel of figure 1 have a higher central peak and the “shoulders” are somewhat wider than what is predicted by the Gaussian fit. This mismatch in the tails is more visible in the semi-log plot shown in panel (b). This demonstrates that a normal distribution is probably not a very accurate assumption. Sigma, the standard deviation, is typically used as a measure of the relative magnitude of market moves and as a rough proxy for the occurrence of such events. The normal distribution places the odds of a minus-5 sigma swing at only 2.86×10-5 %. In other words, assuming 252 trading days per year, a drop of this magnitude should occur once in every 13,000 years! However, an examination of S&P returns over the 37-year period cited shows drops of 5 standard deviations or greater on 15 occasions. Assuming a normal distribution would consistently underestimate the occurrence of tail events.

We conducted a subsequent analysis focusing on the daily returns of SPY, a popular exchange-traded fund (ETF). This ETF tracks 503 component instruments. Using returns from July 01, 2016 through June 31, 2017, we tested each component instrument’s return vector for normality using the Chi-Square Test, the Kurtosis estimate, and a visual inspection of the Q-Q plot. Brief explanations of these methods are provided below.

Chi-Square Test

This is a goodness-of-fit test that assumes a specific data distribution (Null hypothesis) and then tests that assumption. The test evaluates the deviations of the model predictions (Normal distribution, in this instance) from empirical values. If the resulting computed test statistic is large, then the observed and expected values are not close and the model is deemed a poor fit to the data. Thus, the Null hypothesis assumption of a specific distribution is rejected.

Kurtosis

The kurtosis of any univariate standard-Normal distribution is 3. Any deviations from this value imply that the data distribution is correspondingly non-Normal. An example is illustrated in Figures 2, 3, and 4, below.

Q-Q Plot

Quantile-quantile (QQ) plots are graphs on which quantiles from two distributions are plotted relative to each other. If the distributions correspond, then the plot appears linear. This is a visual assessment rather than a quantitative estimation. A sample set of results is shown in Figures 2, 3, and 4, below.

Figure Two: Year’s Returns for Exxon

Figure 2. The left panel shows the histogram of a year’s returns for Exxon (XOM). The null hypothesis was rejected with the conclusion that the data is not normally distributed. The kurtosis was 6 which implies a deviation from normality. The Q-Q plot in the right panel reinforces these conclusions.

Figure Three: Year’s Returns for Boeing

Figure 3. The left panel shows the histogram of a year’s returns for Boeing (BA). The data is not normally distributed and shows a significant skewness also. The kurtosis was 12.83 and implies a significant deviation from normality. The Q-Q plot in the right panel confirms this.

For the sake of comparison, we also show returns that exhibit normality in the next figure.

Figure Four: Year’s Returns for Xerox

The left panel shows the histogram of a year’s returns for Xerox (XRX). The data is normally distributed, which is apparent from a visual inspection of both panels. The kurtosis was 3.23 which is very close to the value for a theoretical normal distribution.

Machine learning literature has several suggestions for addressing this problem, including Kernel Density Estimation and Mixture Density Networks. If the data exhibits multi-modal behavior, learning a multi-modal mixture model is a possible approach.

Stationarity Assumption

In addition to normality, we also make untested assumptions regarding stationarity. This critical assumption is implicit when computing covariances and correlations. We also tend to overlook insufficient sample sizes. As observed earlier, the SPY dataset we had at our disposal consisted of 503 instruments, with around 250 returns per instrument. The number of observations is much lower than the dimensionality of the data. This will produce a covariance matrix which is not full-rank and, consequently, its inverse will not exist. Singular covariance matrices are highly problematic when computing the risk-return efficiency loci in the analysis of portfolios. We tested the returns of all instruments for stationarity using the Augmented Dickey Fuller (ADF) test. Several return vectors were non-stationary. Non-stationarity and sample size issues can’t be wished away because the financial markets are fluid with new firms coming into existence and existing firms disappearing due bankruptcies or acquisitions. Consequently, limited financial histories will be encountered and must be dealt with.

This is a problem where machine learning can be profitably employed. Shrinkage methods, Latent factor models, Empirical Bayes estimators and Random matrix theory based models are widely published techniques that are applicable here.

Portfolio Performance Analysis

Once issues surrounding untested assumptions have addressed, we can focus on portfolio performance analysis–a subject with a vast collection of books and papers devoted to it. We limit our attention here to one aspect of portfolio performance analysis – an inquiry into the clustering behavior of stocks in a portfolio.

Books on portfolio theory devote substantial space to the discussion of asset diversification to achieve an optimum balance of risk and return. To properly diversify assets, we need to know if resources have been over-allocated to a specific sector and, consequently, under-allocated to others. Cluster analysis can help to answer this. A pertinent question is how to best measure the difference or similarity between stocks. One way would be to estimate correlations between stocks. This approach has its own weaknesses, some of which have been discussed in earlier sections. Even if we had a statistically significant set of observations, we are faced with the problem of changing correlations during the course of a year due to structural and regime shifts caused by intermittent periods of stress. Even in the absence of stress, correlations can break down or change due to factors that are endogenous to individual stocks.

We can estimate similarity and visualize clusters using histogram analysis. However, histograms eliminate temporal information. To overcome this constraint, we used Spectral Clustering, which is a machine learning technique that explores cluster formation without neglecting temporal information.

Figures 5 to 7 display preliminary results from our cluster analysis. Analyses like this will enable portfolio managers to realize clustering patterns and their strengths in their portfolios. They will also help guide decisions on reweighting portfolio components and diversification.

Figures 5-7: Cluster Analyses

Figure 5. Cluster analysis of a limited set of stocks is shown here. The labels indicate the names of the firms. Clusters are illustrated by various colored bullets, and increasing distances indicate decreasing similarities. Within clusters, stronger affinities are indicated by greater connecting line weights.

The following figures display magnified views of individual clusters.

Figure 6. We can see that Procter & Gamble, Kimberly Clark and Colgate Palmolive form a cluster (top left, dark green bullets). Likewise, Bank of America, Wells Fargo and Goldman Sachs form a cluster (top right, light green bullets). This is not surprising as these two clusters represent two sectors: consumer products and banking. Line weights are correlated to affinities within sectors.

Figure 7. The cluster on the left displays stocks in the technology sector, while the clusters on the right represent firms in the defense industry (top) and the energy sector (bottom).

In this post, we raised questions about standard assumptions that are made when analyzing portfolios. We also suggested possible solutions from machine learning literature. We subsequently analyzed one year’s worth of returns of SPY to identify clusters and their strengths and discussed the value of such an analysis to portfolio managers in evaluating risk and reweighting or diversifying their portfolios.


Prepayment Speeds Analysis of Freddie Mac Specified Pools

Are there differences in the prepayment speeds of various Freddie Mac specified pools?

Specified pools are comprised of loans with more homogenous characteristics than the typical TBA pool. For example, loans with original balances of less than $85,000 (a low loan balance, or LLB, specified pool). For this analysis, we will look at the prepayment rates of low loan balance (LLB), medium loan balance (MLB, $85,000 < original loan balance <= $110,000), high loan balance (HLB, $110,000 < original loan balance < = $150,000), investor (original loan balance < $150,000 and 100% investment properties), and low FICO pools (original loan balance < $150,000 and FICO < 700). And to ensure an apples-to-apples comparison, we will restrict the analysis to 4%, 2014 vintage pools.

Background information on specified pools can be found at https://www.fanniemae.com/content/news/specified-pool-pay-up-commentary.pdf.

Watch the short video to find out the answer and to see just how easy this can be done with RS Edge.


Mitigating EUC Risk Using Model Validation Principles

The challenge associated with simply gauging the risk associated with “end user computing” applications (EUCs)— let alone managing it—is both alarming and overwhelming. Scanning tools designed to detect EUCs can routinely turn up tens of thousands of potential files, even at not especially large financial institutions. Despite the risks inherent in using EUCs for mission-critical calculations, EUCs are prevalent in nearly any institution due to their ease of use and wide-ranging functionality.

This reality has spurred a growing number of operational risk managers to action. And even though EUCs, by definition, do not rise to the level of models, many of these managers are turning to their model risk departments for assistance. This is sensible in many cases because the skills associated with effectively validating a model translate well to reviewing an EUC for reasonableness and accuracy.  Certain model risk management tools can be tailored and scaled to manage burgeoning EUC inventories without breaking the bank.

Identifying an EUC

One risk of reviewing EUCs using personnel accustomed to validating models is the tendency of model validators to do more than is necessary. Subjecting an EUC to a full battery of effective challenges, conceptual soundness assessments, benchmarking, back-testing, and sensitivity analyses is not an efficient use of resources, nor is it typically necessary. To avoid this level of overkill, reviewers ought to be able to quickly recognize when they are looking an EUC and when they are looking at something else.

Sometimes the simplest definitions work best: an EUC is a spreadsheet.

While neither precise, comprehensive, nor 100 percent accurate, that definition is a reasonable approximation. Not every EUC is a spreadsheet (some are Access databases) but the overwhelming majority of EUCs we see are Excel files. And not every Excel file is an EUC—conference room schedules and other files in Excel that do not do any serious calculating do not pose EUC risk. Some Excel spreadsheets are models, of course, and if an EUC review discovers quantitative estimates in a spreadsheet used to compute forecasts, then analysts should be empowered to flag such applications for review and possible inclusion in the institution’s formal model inventory. Once the dust has settled, however, the final EUC inventory is likely to contain almost exclusively spreadsheets.

Building an EUC Inventory

EUCs are not models, but much of what goes into building a model inventory applies equally well to building an EUC inventory. Because the overwhelming majority of EUCs are Excel files, the search for latent EUCs typically begins with an automated search for files with .xls and .xlsx extensions. Many commercially available tools conduct these sorts of scans. The exercise typically returns an extensive list of files that must be sifted through.

Simple analytical tools, such as Excel’s “Inquire” add-in, are useful for identifying the number and types of unique calculations in a spreadsheet as well as a spreadsheet’s reliance on external data sources. Spreadsheets with no calculations can likely be excluded from further consideration from the EUC inventory. Likewise, spreadsheets with no data connections (i.e., links to or from other spreadsheets) are unlikely to qualify for the EUC inventory because such files do not typically have significant downstream impact. Spreadsheets with many tabs and hundreds of unique calculations are likely to qualify as EUCs (at least—if not as models) regardless of their specific use.

Most spreadsheets fall somewhere between these two extremes. In many cases, questioning the owners/users of identified spreadsheets is necessary to determine its use and help ascertain any potential institutional risks if the spreadsheet does not work as intended. When making inquiries of spreadsheet owners, open-ended questions may not always be as helpful as those designed to elicit a narrow band of responses. Instead of asking, “What is this spreadsheet used for?” A more effective request would be, “What other systems and files is this spreadsheet used to populate?”

Answers to these sorts of questions aid not only in determining whether a spreadsheet qualifies as an EUC but the risk-rating of the EUC as well.

Testing Requirements

For now, regulator interest in seeing that EUCs are adequately monitored and controlled appears to be outpacing any formal guidance on how to go about doing it.

Absent such guidance, many institutions have started approaching EUC testing like a limited-scope model validation. Effective reviews include a documentation review, a tie-out of input data to authorized, verified sources, an examination of formulas and coding, a form of benchmarking, and an overview of spreadsheet governance and controls.

Documentation Review

Not unlike a model, each EUC should be accompanied by documentation that explains its purpose and how it accomplishes what it intends to do. Documentation should describe the source of input data and what the EUC does with it. Sufficient information should be provided for a reasonably informed reviewer to re-create the EUC based solely on the documentation. If a reviewer must guess the purpose of any calculation, then the EUC’s documentation is likely deficient.

Input Review

The reviewer should be able to match input data in the EUC back to an authoritative source. This review can be performed manually; however, any automated lookups used to pull data in from other files should be thoroughly reviewed, as well.

Formula and Function Review

Each formula in the EUC should be independently reviewed to verify that it is consistent with its documented purposes. Reviewers do not need to test the functionality of Excel—e.g., they do not need to test arithmetic functions on a calculator—however, formulas and functions should be reviewed for reasonableness.

Benchmarking

A model validation benchmarking exercise generally consists of comparing the subject model’s forecasts with those of a challenger model designed to do the same thing, but perhaps in a different way. Benchmarking an EUC, in contrast, typically involves constructing an independent spreadsheet based on the EUC documentation and making sure it returns the same answers as the EUC.

Governance and Controls

An EUC should ideally be subjected to the same controls requirements as a model. Procedures designed to ensure process checks, access and change control management, output reconciliation, and tolerance levels should be adequately documented.

The extent to which these tools should be applied depends largely on how much risk an EUC poses. Properly classifying EUCs as high-, medium, or low-risk during the inventory process is critical to determining how much effort to invest in the review.

Other model validation elements, such as back-testing, stress testing, and sensitivity analysis, are typically not applicable to an EUC review. Because EUCs are not predictive by definition, these sorts of analyses are not likely to bring much value to an EUC review .

Striking an appropriate balance — leveraging effective model risk management principles without doing more than needs to be done — is the key to ensuring that EUCs are adequately accounted for, well controlled, and functioning properly without incurring unnecessary costs.


The Non-Agency MBS Market: Re-Assessing Securitization Market Conditions

Since the financial crisis began in 2007, the “Non-Agency” MBS market, i.e., securities neither issued nor guaranteed by Fannie Mae, Freddie Mac, or Ginnie Mae, has been sporadic and has not rebounded from pre-crisis levels. In recent months, however, activity by large financial institutions, such as AIG and Wells Fargo, has indicated a return to the issuance of Non-Agency MBS. What is contributing to the current state of the securitization market for high-quality mortgage loans? Does the recent, limited-scale return to issuance by these institutions signal an increase in private securitization activity in this sector of the securitization market? If so, what is sparking this renewed interest?

 

The MBS Securitization Market

Three entities – Ginnie Mae, Fannie Mae, and Freddie Mac – have been the dominant engine behind mortgage-backed securities (MBS) issuance since 2007. These entities, two of which remain in federal government conservatorship and the third a federal government corporation, have maintained the flow of capital from investors into guaranteed MBS and ensured that mortgage originators have adequate funds to originate certain types of single-family mortgage loans.

Virtually all mortgage loans backed by federal government insurance or guaranty programs, such as those offered by the Federal Housing Administration and the Department of Veterans Affairs, are issued in Ginnie Mae pools. Mortgage loans that are not eligible for these programs are referred to as “Conventional” mortgage loans. In the current market environment, most Conventional mortgage loans are sold to Fannie Mae and Freddie Mac (i.e. “Conforming” loans) and are securitized in Agency-guaranteed pass-through securities.

 

The Non-Agency MBS Market

Not all Conventional mortgage loans are eligible for purchase by Fannie Mae or Freddie Mac, however, due to collateral restrictions (i.e., their loan balances are too high or they do not meet certain underwriting requirements). These are referred to as “Non-Conforming” loans and, for most of the past decade, have been held in portfolio at large financial institutions, rather than placed in private, Non-Agency MBS. The Non-Agency MBS market is further divided into sectors for “Qualified Mortgage” (QM) loans, non-QM loans, re-performing loans and nonperforming loans. This post deals with the securitization of QM loans through Non-Agency MBS programs.

Since the crisis, Non-Agency MBS issuance has been the exclusive province of JP Morgan and Redwood Trust, both of which continue to issue a relatively small number of deals each year. The recent entry of AIG into the Non-Agency MBS market and, combined with Wells Fargo’s announcement that it intends to begin issuing as well, makes this a good time to discuss reasons why these institutions with other funding sources available to them are now moving back to this securitization market sector.

 

Considerations for Issuing QM Loans

Three potential considerations may lead financial institutions to investigate issuing QM Loans through Non-Agency MBS transactions:

  • “All-In” Economics
  • Portfolio Concentration or Limitations
  • Regulatory Pressures

Investigate “All-In” Economics

Over the long-term, mortgage originators gravitate to funding sources that provide the lowest cost to borrowers and profitability for their firms.  To improve the “all-in” economics of a Non-Agency MBS transaction, investment banks work closely with issuers to broaden the investor base for each level of the securitization capital structure.  Partly due to the success of the Fannie Mae and Freddie Mac Credit Risk Transfer transactions, there appears to be significant interest in higher-yielding mortgage-related securities at the lower-rated (i.e. higher risk) end of the securitization capital structure. This need for higher yielding assets has also increased demand for lower-rated securities in the Non-Agency MBS sector.

However, demand from investors at the higher-rated end of the securitization capital structure (i.e. ‘AAA’ and ‘AA’ securities) has not resulted in “all-in” economics for a Non-Agency MBS transaction that surpass the economics of balance sheet financing provided by portfolios funded with low deposit rates or low debt costs. If deposit rates and debt costs remain at historically low levels, the portfolio funding alternative will remain attractive. Notwithstanding the low interest rate environment, some institutions may develop operational capabilities for Non-Agency MBS programs as a risk mitigation process for future periods where balance sheet financing alternatives may not be as beneficial.

 

Portfolio Concentration or Limitations

Due to the lack of robust investor demand and unfavorable economics in Non-Agency MBS, many banks have increased their portfolio exposure to both fixed-rate and intermediate-adjustable-rate QM loans. The ability to hold these mortgage loans in portfolio has provided attractive pricing to a key customer demographic and earned an attractive net interest rate margin during the historical low-rate environment. While bank portfolios have provided an attractive funding source for Non-Agency QM loans, some financial institutions may attempt to develop diversified funding sources in response to regulatory pressure or self-imposed portfolio concentration limits. Selling existing mortgage portfolio assets into the Non-Agency MBS securitization market is one way in which financial institutions might choose to reduce concentrated mortgage risk exposure.

 

Regulatory Pressure

Some financial institutions may be under pressure from their regulators to demonstrate their ability to sell assets out of their mortgage portfolio as a contingency plan. The Non-Agency MBS market is one way of complying with these sorts of regulatory requests. Developing a contingency ability to tap Non-Agency MBS markets develops operational capabilities under less critical circumstances, while assessing the time needed by the institution to liquidate such assets through securitization. This early establishment of securitization functionalities is a prudent activity for those institutions who foresee the possibility of securitization as a future funding option.

While the Non-Agency MBS market has been dormant for most of the past decade, some financial institutions that have relied upon portfolio funding now appear to be testing the current viability of the Non-Agency MBS market. Other mortgage originators would be wise to take notice of these events, monitor activity in these markets, and assess the viability of this alternative funding source for their on-Conforming QM Loans. With the continued issuance by JP Morgan and Redwood Trust and new entrants such as AIG and Wells Fargo, -Non-Agency MBS market activity should be monitored by other mortgage originators to determine whether securitization has the potential to provide an alternative funding source for future lending activity.

In our next article on the Non-Agency MBS market, we will review the changes in due diligence practices, loan-level data disclosures, the representation and warranty framework, and the ratings process made by securitization market participants and the impact of these changes on the Non-Agency MBS market segment.


Stress Testing Banks: DFAST/CCAR

Complying with the DFAST/CCAR requirements within an existing quantitative models and model risk management framework is one of the most daunting of the many recent challenges banks, Bank Holding Companies (BHC) and some Investment Holding Companies (IHC) currently face. The Dodd-Frank Act Stress Tests (DFAST) require all financial institutions with total assets above $10 billion to do stress tests on their portfolio and balance sheet. The Comprehensive Capital Analysis and Review (CCAR) is generally required to be completed once a bank’s total assets are above $50 billion. The objective of both exercises is to simulate a bank’s balance sheet performance and losses in a hypothetical severe economic downturn over the next nine quarters.1 Given this common objective, most risk managers consider and complete both exercises together.

With any DFAST/CCAR submission, affected financial institutions are not only required to complete the various mandatory balance sheet and capital templates, but also to submit the standard model risk documents for every model. Institutions cannot make any capital distributions (e.g., pay dividends) unless their regulator indicates in writing a non-objection to their submitted capital plan. Since all models are required to be validated before use, financial institutions are required to validate all their DFAST/CCAR models and include each model’s validation as a part of their submission package.

Below is a table summarizing an institution’s responsibility by total asset size and type of stress test:

Dodd-Frank Act Stress Tests (DFAST)

The Dodd-Frank Act Stress Tests (DFAST) are forward looking quantitative evaluations of the impact of stressed macroeconomic conditions on a bank’s capital. This involves stress testing a bank’s balance sheet over both pre-subscribed macroeconomic scenarios provided by the Office of the Comptroller of the Currency (OCC) and Federal Reserve and those required to be created internally. The Dodd-Frank Act, which was enacted in response to the 2008-09 global financial crisis, required the Fed and the OCC to conduct annual stress tests for institutions with more than $10 billion in total assets. Institutions above $50 billion in total assets are required to complete both the mid-cycle and supervisory stress tests. Previously, only institutions above $50 billion in total assets were required to conduct stress testing on internally developed macroeconomic scenarios. However, after the DFAST 2016 submission, all DFAST institutions will be required to conduct these internal stress tests.

DFAST submissions have historically been required to be completed by the end of Q1 or the beginning of Q2, with the DFAST 2016 submission deadline for CCAR banks set at April 5, 2017. The composition of a DFAST submission includes all capital and balance sheet components. A template is provided by the OCC for use in submitting an institution’s capital plan. Institutions are required to use a variety of macroeconomic scenarios, from both the regulator and the bank’s internal forecasts, to produce the DFAST capital figures.

Comprehensive Capital Analysis Review (CCAR)

The largest Bank Holding Companies (BHCs) are required to go one step further by completing both DFAST and the Comprehensive Capital Analysis and Review (CCAR) stress tests with the Federal Reserve. The CCAR stress test generally completes most of the DFAST requirements but adds additional quantitative and qualitative layers for the computation and submission of the BHC’s capital plan. Institutions must complete CCAR requirements if they meet the following conditions set forth by the Federal Reserve:

CCAR has two different aspects which must be completed. The first is a quantitative capital plan which, like the DFAST capital plan, is a quantitative forecast of the bank’s capital on a variety of different macroeconomic scenarios. Also like DFAST, the capital plan has a presubscribed template which must be reviewed and approved by internal management and the board of directors before submission to the Fed. In both DFAST and CCAR, regulators can object to the bank’s capital plan, requiring the institution to revise and resubmit their capital plan.

The second component of CCAR reviews the qualitative aspects of the institution’s capital plan with the objective of ensuring that the submitted capital plan was created using strong risk management, good governance, and proper internal controls and policies. This qualitative review considers several key aspects of the institution, including the following:

  • Stress testing method, including the generation of the internal BHC scenarios
  • Internal controls to ensure an accurate and robust capital plan
  • Model governance, including documentation and model validation
  • Internal policies and procedures with clear and precise separation of responsibilities and approval processes

Firms are required to complete both the quantitative and qualitative CCAR requirements if they are either a LISCC firm or are large and complex. A Large Institution Supervision Coordination Committee BHC or those classified as large and complex by the Fed are those banks with any of the following characteristics:

  • Have $250 billion or more in total consolidated assets
  • Have an average total non-bank assets of $75 billion or more
  • Are US global systemically important banks

Those firms which do not meet each of the three requirements listed above but are above $50 billion in total assets are determined to be large and non-complex firms. These firms are not subjected to CCAR’s qualitative review component but are still required to submit their quantitative capital plan for supervisory approval.

Stress Scenarios

To populate the capital plan, institutions use a variety of stress scenarios to obtain stressed values for balance sheet line items. The sophistication of the chosen technique varies significantly, not only based on the size of the institution, but also on its stated objective. This approach can usually be split between models and non-models. A model in the DFAST/CCAR context has the same model definition used by supervisory guidance SR 11-7/OCC 2011-12. Models are typically used within the DFAST/CCAR framework to forecast out those assets and liabilities which the institution has determined there is high risk and a certain level of uncertainty. The use of a model or a tool to produce a DFAST/CCAR capital forecast is at the discretion of the institution with regulatory approval required.

The macroeconomic stress scenarios are divided into the following three categories based on severity and impact:

  • Baseline
  • Adverse
  • Severely Adverse

The baseline stress scenario typically comprises the industry and regulatory consensus forecasts of the economy into the future and serves as the beginning benchmark of a bank’s performance against the stress scenarios. The adverse and severely adverse stress scenarios convey a what-if analysis of the economy to show slowing growth or a recession. The reasoning behind this approach traces back to the 2008-09 financial crisis where capital markets nearly collapsed, leaving institutions with little held capital vulnerable to potential liquidity and solvency issues. The adverse and severely adverse scenarios are run in this context to see how an institution’s balance sheet would perform through an event similar to or worse than the 2008-09 crisis.

In most cases, institutions leverage currently existing models within their inventory to produce the necessary DFAST/CCAR stress forecasts. A good example of this is the forecasting of an institution’s interest rate risk (IRR). Most institutions forecast IRR using a model to obtain projected values for both net interest income (NII) and/or the market value of portfolio equity (MVPE). Since this model already exists within an institution for this purpose, the existing model can be leveraged to apply the stressed macroeconomic scenarios and determine the behavior of IRR over the DFAST/CCAR forecast horizon.

A common misconception, due to its name, is that the severely adverse stress scenario should always have worse macroeconomic performance and a more significant impact on an institution’s capital than the adverse stress scenario. While the severely adverse scenario does generally give a more severe impact on a bank’s capital, there are cases where the adverse could have a much more severe impact. This is due to the nature of the scenario. For instance, the adverse scenario could focus on a 3% increase in the unemployment rate, while the severely adverse could decrease real GDP growth to -1% per annum. If the unemployment rate has a much greater impact on the institution’s balance sheet versus real GDP growth, then the adverse scenario will have a much larger impact than the severely adverse scenario.

The macroeconomic stress scenarios used in DFAST/CCAR are divided into two groups based on their source. The first group, which is required of all institutions required to complete DFAST/CCAR, contains the regulatory prescribed scenarios. These are macroeconomic scenarios supplied by the regulators themselves. These forecasts are quarterly and cover a wide range of macroeconomic variables, including real GDP growth, inflation and unemployment, among others. These scenarios are provided for both the domestic U.S. economy and overseas areas, including Europe and Developing Asia.

The second group contains the macroeconomic stress scenarios put together internally by the institution itself. Prior to DFAST 2016, only institutions with total assets exceeding $50 billion were required to produce their own scenarios. This distinction, however, was removed for DFAST 2016 and going forward. These internal scenarios are generally similar in both composition and effect to the regulatory scenarios but geared specifically for what the institution’s balance sheet is holding and where it operates. For instance, you would expect an institution whose footprint is limited to California to focus on the macroeconomic performance of California against the rest of the country in terms of forecasting potential macroeconomic recessions. Institutions usually generate their own macroeconomic forecasts using a combination of statistical modeling, industry best practice, and experience. These models and their construction will be the topic of a future post.

Conclusion

While the implementation of DFAST/CCAR into an institution can seem like a daunting and confusing task, understanding its objectives as well as how to leverage your existing model inventory can make this exercise rewarding in terms of risk management. Proper execution of the DFAST/CCAR process instills institutions with confidence that they have a sufficient capital reserve to ride out the next storm when it hits.


[1] Nine quarters is used since the last quarter of the year preceding the DFAST/CCAR submission is considered a part of the scenarios. For example, the 2015 DFAST/CCAR scenarios are provided from 2014 Q4 to 2016 Q4


Advantages and Disadvantages of Open Source Data Modeling Tools

Using open source data modeling tools has been a topic of debate as large organizations, including government agencies and financial institutions, are under increasing pressure to keep up with technological innovation to maintain competitiveness. Organizations must be flexible in development and identify cost-efficient gains to reach their organizational goals, and using the right tools is crucial. Organizations must often choose between open source software, i.e., software whose source code can be modified by anyone, and closed software, i.e., proprietary software with no permissions to alter or distribute the underlying code.

Mature institutions often have employees, systems, and proprietary models entrenched in closed source platforms. For example, SAS Analytics is a popular provider of proprietary data analysis and statistical software for enterprise data operations among financial institutions. But several core computations SAS performs can also be carried out using open source data modeling tools, such as Python and R. The data wrangling and statistical calculations are often fungible and, given the proper resources, will yield the same result across platforms.

Open source is not always a viable replacement for proprietary software, however. Factors such as cost, security, control, and flexibility must all be taken into consideration. The challenge for institutions is picking the right mix of platforms to streamline software development.  This involves weighing benefits and drawbacks.

Advantages of Open Source Programs

The Cost of Open Source Software

The low cost of open source software is an obvious advantage. Compared to the upfront cost of purchasing a proprietary software license, using open source programs seems like a no-brainer. Open source programs can be distributed freely (with some possible restrictions to copyrighted work), resulting in virtually no direct costs. However, indirect costs can be difficult to quantify. Downloading open source programs and installing the necessary packages is easy and adopting this process can expedite development and lower costs. On the other hand, a proprietary software license may bundle setup and maintenance fees for the operational capacity of daily use, the support needed to solve unexpected issues, and a guarantee of full implementation of the promised capabilities. Enterprise applications, while accompanied by a high price tag, provide ongoing and in-depth support of their products. The comparable cost of managing and servicing open source programs that often have no dedicated support is difficult to determine.

Open Source Talent Considerations

Another advantage of open source is that it attracts talent who are drawn to the idea of sharable and communitive code. Students and developers outside of large institutions are more likely to have experience with open source applications since access is widespread and easily available. Open source developers are free to experiment and innovate, gain experience, and create value outside of the conventional industry focus. This flexibility naturally leads to more broadly skilled inter-disciplinarians. The chart below from Indeed’s Job Trend Analytics tool reflects strong growth in open source talent, especially Python developers.

From an organizational perspective, the pool of potential applicants with relevant programming experience widens significantly compared to the limited pool of developers with closed source experience. For example, one may be hard-pressed to find a new applicant with development experience in SAS since comparatively few have had the ability to work with the application. Key-person dependencies become increasingly problematic as the talent or knowledge of the proprietary software erodes down to a shrinking handful of developers.

Job Seekers Interests via Indeed

*Indeed searches millions of jobs from thousands of job sites. The jobseeker interest graph shows the percentage of jobseekers who have searched for SAS, R, and python jobs.

*Indeed searches millions of jobs from thousands of job sites. The jobseeker interest graph shows the percentage of jobseekers who have searched for SAS, R, and python jobs.

Support and Collaboration

The collaborative nature of open source facilitates learning and adapting to new programming languages. While open source programs are usually not accompanied by the extensive documentation and user guides typical of proprietary software, the constant peer review from the contributions of other developers can be more valuable than a user guide. In this regard, adopters of open source may have the talent to learn, experiment with, and become knowledgeable in the software without formal training.

Still, the lack of support can pose a challenge. In some cases, the documentation accompanying open source packages and the paucity of usage examples in forums do not offer a full picture. For example, RiskSpan built a model in R that was driven by the available packages for data infrastructure – a precursor to performing statistical analysis – and their functionality. R does not have an active support solutions line and the probability of receiving a response from the author of the package is highly unlikely. This required RiskSpan to thoroughly vet packages.

Flexibility and Innovation

Another attractive feature of open source is its inherent flexibility. Python allows users to use different integrated development environments (IDEs) that have multiple different characteristics or functions, as compared to SAS Analytics, which only provides SAS EG or Base SAS. R makes possible web-based interfaces for server-based deployments. These functionalities grant more access to users at a lower cost. Thus, there can be more firm-wide development and participation in development. The ability to change the underlying structure of open source makes it possible to mold it per the organization’s goals and improve efficiency.

Another advantage of open source is the sheer number of developers trying to improve the software by creating many functionalities not found in their closed source equivalent. For example, R and Python can usually perform many functions like those available in SAS, but also have many capabilities not found in SAS: downloading specific packages for industry specific tasks, scraping the internet for data, or web development (Python). These specialized packages are built by programmers seeking to address the inefficiencies of common problems. A proprietary software vendor does not have the expertise nor the incentive to build equivalent specialized packages since their product aims to be broad enough to suit uses across multiple industries.

RiskSpan uses open source data modeling tools and operating systems for data management, modeling, and enterprise applications. R and Python have proven to be particularly cost effective in modeling. R provides several packages that serve specialized techniques. These include an archive of packages devoted to estimating the statistical relationship among variables using an array of techniques, which cuts down on development time. The ease of searching for these packages, downloading them, and researching their use incurs nearly no cost.

Open source makes it possible for RiskSpan to expand on the tools available in the financial services space. For example, a leading cash flow analytics software firm that offers several proprietary solutions in modeling structured finance transactions lacks the full functionality RiskSpan was seeking.  Seeking to reduce licensing fees and gain flexibility in structuring deals, RiskSpan developed deal cashflow programs in Python for STACR, CAS, CIRT, and other consumer lending deals. The flexibility of Python allowed us to choose our own formatted cashflows and build different functionalities into the software. Python, unlike closed source applications, allowed us to focus on innovating ways to interact with the cash flow waterfall.

Disadvantages of Open Source Programs

Deploying open source solutions also carries intrinsic challenges. While users may have a conceptual understanding of the task at hand, knowing which tools yield correct results, whether derived from open or closed source, is another dimension to consider. Different parameters may be set as default, new limitations may arise during development, or code structures may be entirely different. Different challenges may arise from translating a closed source program to an open source platform. Introducing open source requires new controls, requirements, and development methods.

Redundant code is an issue that might arise if a firm does not strategically use open source. Across different departments, functionally equivalent tools may be derived from distinct packages or code libraries. There are several packages offering the ability to run a linear regression, for example. However, there may be nuanced differences in the initial setup or syntax of the function that can propagate problems down the line. In addition to the redundant code, users must be wary of “forking” where the development community splits on an open source application. For example, R develops multiple packages performing the same task/calculations, sometimes derived from the same code base, but users must be cognizant that the package is not abandoned by developers.

Users must also take care to track the changes and evolution of open source programs. The core calculations of commonly used functions or those specific to regular tasks can change. Maintaining a working understanding of these functions in the face of continual modification is crucial to ensure consistent output. Open source documentation is frequently lacking. In financial services, this can be problematic when seeking to demonstrate a clear audit trail for regulators. Tracking that the right function is being sourced from a specific package or repository of authored functions, as opposed to another function, which may have an identical name, sets up blocks on unfettered usage of these functions within code. Proprietary software, on the other hand, provides a static set of tools, which allows analysts to more easily determine how legacy code has worked over time.

Using Open Source Data Modeling Tools

Deciding on whether to go with open source programs directly impacts financial services firms as they compete to deliver applications to the market. Open source data modeling tools are attractive because of their natural tendency to spur innovation, ingrain adaptability, and propagate flexibility throughout a firm. But proprietary software solutions are also attractive because they provide the support and hard-line uses that may neatly fit within an organization’s goals. The considerations offered here should be weighed appropriately when deciding between open source and proprietary data modeling tools.

Questions to consider before switching platforms include:

  • How does one quantify the management and service costs for using open source programs? Who would work on servicing it, and, once all-in expenses are considered, is it still more cost-effective than a vendor solution?
  • When might it be prudent to move away from proprietary software? In a scenario where moving to a newer open source technology appears to yield significant efficiency gains, when would it make sense to end terms with a vendor?
  • Does the institution have the resources to institute new controls, requirements, and development methods when introducing open source applications?
  • Does the open source application or function have the necessary documentation required for regulatory and audit purposes?

Open source is certainly on the rise as more professionals enter the space with the necessary technical skills and a new perspective on the goals financial institutions want to pursue. As competitive pressures mount, financial institutions are faced with a difficult yet critical decision of whether open source is appropriate for them. Open source may not be a viable solution for everyone—the considerations discussed above may block the adoption of open source for some organizations. However, often the pros outweigh the cons, and there are strategic precautions that can be taken to mitigate any potential risks.


References

 https://www.redhat.com/en/open-source/open-source-way

http://www.stackoverflow.blog/code-for-a-living/how-i-open-sourced-my-way-to-my-dream-job-mohamed-said

https://www.redhat.com/f/pdf/whitepapers/WHITEpapr2.pdf

http://www.forbes.com/sites/benkepes/2013/10/02/open-source-is-good-and-all-but-proprietary-is-still-winning/#7d4d544059e9

https://www.indeed.com/jobtrends/q-SAS-q-R-q-python.html


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