Measurement of Prepayments for Residential Mortgage‐Backed Securities

Abstract

The valuation of residential mortgage-backed securities begins with a projection of a subject security's cash flow. The monthly cash flow from the underlying pool of mortgage loans includes three components: (1) scheduled principal payments (also referred to as amortization), (2) interest payments, and (3) any prepayments. Prepayments are any payments made by borrowers that are in excess of the scheduled principal payment. Consequently, the cash flow depends on the prepayment behavior of the borrowers in the mortgage pool. In addition to prepayments, the expected credit performance of the underlying loans must be projected to estimate a residential mortgage-backed securities cash flow. The sharp deterioration in mortgage performance that emerged in late 2006 led to the realization that prepayments and defaults often had related effects on the performance of these securities, even though they represent very different phenomena. As a result, new terminology has emerged to clarify the different circumstances that result in the early return of principal to investors. Understanding the terms used in the market to define prepayments and default experience, as well as the methodologies used to generate these metrics, is important for the following reasons: efficient risk-based pricing at the origination level; evaluation of relative value within the residential mortgage-backed securities sector (as well as across the fixed income universe); effective hedging and management of prepayment and credit risk exposure; and ex post performance attribution. Keywords: mortgage-backed securities; Residential MBS; agency MBS; nonagency MBS; private label MBS; prepayments; negative convexity; defaults; voluntary; involuntary prepayments; conditional prepayment rate; single monthly mortality rate; Public Securities Association (PSA) prepayment benchmark; home equity prepayment; curve; manufactured housing prepayment; conditional default rate; monthly default rate; constant prepayment rate