Auxiliary model for analyzing the market value of Delta Lloyd Bank mortgages
Home and dry with the Amstelhuys mortgage figures
When IFRS was introduced, Delta Lloyd Bank decided to value its mortgage portfolio at fair value and enter it directly on the balance sheet. That worked well but when the credit crisis came, the portfolio started to show larger value fluctuations according to the model than was the case in practice. Delta Lloyd Bank wanted an auxiliary valuation model to explain those differences and so they brought in Zanders.
Delta Lloyd Bank has placed all its mortgages and associated funding (notes) with Amstelhuys, a subsidiary of Delta Lloyd and its residential mortgages originator. Since the introduction of IFRS, the Amstelhuys balance sheet has been prepared on a fair value basis, with movements in the value of the mortgage portfolio being recognized immediately in the income statement.
“The actual situation was not as bad as the figures showed, but we still wanted to be able to explain the difference.”
Delta Lloyd Bank uses the discounted cash flow method for this: the expected future cash flows for all mortgage contracts are discounted using a single funding margin on top of the swap rate. “This is a relatively simple model with parameters that are easy to read,” explains Rogier de Barbanson, risk manager at Delta Lloyd Bank.
“However, you also lose data with a model like that, as we saw when the financial crisis broke out and the value of the mortgages and notes changed.” The two portfolios began to diverge, which led to shocks in the balance sheet and, more importantly, in the income statement of Amstelhuys. Such fluctuations were out of proportion to the changes in the underlying mortgages in economic terms.
Financial director at Delta Lloyd Gilbert Pluym says: “It is annoying if you can’t explain the fluctuations. For example, we know that the funding costs of mortgages play a major role in times of crisis but we couldn’t see that in our model. As a result, the high quality of our mortgages was not being reflected.”
Spreads per credit class
Delta Lloyd Bank started to look for a consistent valuation method that would be capable of giving an explanation in economic terms of the balance sheet values and their movements while still keeping to the IFRS guidelines.
The bank called in Zanders. Delta Lloyd’s Pluym explains: “We had worked with them before. We knew they had the expertise and that they were able to deliver quickly. That was important because we wanted to have the calculations with the new model completed before the year-end accounts, so that we could use the results as supporting evidence.
A nice thing about Zanders is also that you always have direct contact with the people making the model.” In this case, the modelers were Gerbert van Grootheest, Mark van den Berg, and Steffen Pang. They proposed combining the existing discounted cash flow method with a tranche approach used for securitized mortgages.
The contract details are used to assign the nominal mortgage principal amounts to credit classes (AAA, AA, A, BBB, BB or B). This means the margins can be determined per credit class. This then allows changes in the market value to be traced to changes in market interest rates, credit margins, contract details or model parameters. Changes in the lending risk should, for instance, be reflected in the value of both the mortgages and the associated notes.
Obviously, the new model was not implemented straight away, as Zanders consultant Gerbert van Grootheest explains: “We took the time for a thorough examination of its principles, together with Delta Lloyd Bank.
For instance, we used the model initially to analyze one section of the portfolio and one securitization. Then we analyzed the entire portfolio, showing a breakdown of the results by portfolio section as well. That gave a good picture of the differences and agreements with the old valuation method.” Eventually, the positions for every quarter in 2009 were analyzed as well.
The pressure of the deadline meant that some overtime was required. “But,” says Van den Berg, “that was the case for everyone. The people at Delta Lloyd Bank supplied their figures as required and on time, and they asked critical questions. It’s really good to have that level of involvement.” Delta Lloyd Bank will continue to use the old method for the time being; the Zanders model is mainly being used as a supplementary tool to check and explain the results.
Pluym says: “That is sufficient for reporting purposes. What is more, as of 2009 new mortgages are already being entered at their nominal value and there will probably be a lot more changes before 2013.” However, the new model will not have a chance to gather dust according to Delta Lloyd’s De Barbanson, who says “We are also using it to determine economic capital, for instance.”
His colleague nods. “And as a management instrument it is also in line with the direction we want to take. The model is giving us a much better understanding of the mortgage portfolio. We are better able to determine the quality of our products and give supporting arguments for our strategic decisions, for example if we decide to focus on price levels. In short, the Zanders model is multipurpose!” Gerbert van Grootheest replies: “Oh, you are still calling it the Zanders model. But it really is your model.”