Prepayment Models

The PSA standard benchmark discussed in the previous section assumes certain prepayment rates and can be used to calculate the prepayment proceeds of a mortgage. It is not, strictly speaking, a prepayment model, because it cannot be used to estimate actual prepayments of a mortgage pool. A prepayment model does attempt to do this, by modeling the statistical relationships between the various factors that affect the level of prepayment. These factors are the current mortgage rate, the characteristics of the mortgages in the pool, seasonal influences, and the general business cycle. 

The housir market and mortgage activity also appear to follow seasonal patterns. Spring and summer see the strongest action, winter the weakest. 

Monthly prepayment rate= (Refinancing Incentive) x(Season multiplier) 

---

The PSA standard benchmark discussed in the previous section assumes certain prepayment rates and can be used to calculate the prepayment proceeds of a mortge e. It is not, strictly speaking, a prepayment model, because it... 

Association of Managed Healthcare Organizations (AMHO) national trade association for open model managed care organizations, at-risk accepting prepayment as foil coverage for a predetermined health care benefit having to assume the financial liability for any loss which occurs when premiums paid are less than the cost of services provided. 

Following the substitution period, the transaction typically enters the amortisation period, during which principal collected from receivables is passed through to noteholders. This may lead to a degree of variability in the average life of the security if the borrowers repay their loans more quickly or slowly than the modelled prepayment speed used to price the notes. Exhibit 14.10 shows a simplified paydown structure for the FIAT 1 transaction. 

Some lending institutions penalize borrowers who retire their loans early. In the United States, prepayment penalties are levied only for commercial mortgages, not for residential ones (both are penalized in the United Kingdom). Residential lenders, therefore, cannot be certain of the cash flows they will receive. This is known as prepayment risk. The uncertainty of mortgages cash flows, and the risk associated with it, is passed on to the securities backed by the loans. In this way, an MBS is similar to a callable bond, with the call exercisable at the discretion of the borrowers, and, as will be explained later, it can be valued using a similar pricing model. 

An investor acquiring a pool of mortgt es from a lender measures the amount of associated prepayment risk by using a financial model to project the level of expected future payments. Although it is impossible to evaluate with any accuracy the prepayment potential of an individual mortgage, such analysis is reasonable for a large pool of loans. This is similar to what actuaries do when they assess the future liability of an insurer that has written personal pension contracts. The level of prepayment risk for a pool of loans is lower than that for an individual mortgt e. 

The projected monthly principal prepayment, which is an expected figure only and not a model forecast, is given by (14.11). 

There are a number of ways to calculate the yield on a mortgage-backed bond. One of the most common is the static cash flow model. This assumes a single prepayment rate to estimate the cash flows for the bond and does not take into account how changes in market conditions might affect the prepayment pattern. 

Effective duration is essentially approximate duration where P and P are obtained using a valuation model—such as a static cash flow model, a binomial model, or a simulation model—that incorporates the eflFect of a change in interest rates on the expected cash flows. The values of P and T, depend on the assumed prepayment rate. Generally analysts assume a higher prepayment rate when the interest rate is at the lower level of the two rates—interest and prepayment. 

---