Mortgage Prepayment Float

Abstract

TYLER T. YANG is with Price Waterhouse. is article is a theoretical and empirical analysis of the value of mortgage servicers’ net prepayment float. Net prepayment float is the investment income on prepaid principal and interest prior to remittance to the ultimate mortgage note holder. Float income is potentially an important component of servicers’ overall profitability, but its value and risk cannot be estimated easily. We develop a pricing model of float and use it to empirically analyze the value and risk of float during a thirteen-year sample period. For a fee, a mortgage servicer performs the role of managing the mortgage payment process for an investor or the ultimate purchaser of the mortgage note. Servicing includes collection of monthly payments from borrowers, the transfer of principal and interest payments to investors, the management of escrow accounts, and the handhng of delinquencies and foreclosures.2 The servicing fee varies with the type of loan, but ranges between 25 and 50 basis points of the unpaid balance. Occasionally, servicers earn additional income from late fee charges assessed against delinquent borrowers. In addition, servicing provides a valuable customer base for loan and deposit products, insurance, and investment services that have the potential for materially influencing the returns and risks of mortgage lenders. In short, the value of the servicing contract is a significant component of the overall profitability of primary mortgage lenders, One aspect of that profit is the value of income received from the mortgage flow. The value and volatility of float income depends upon prepayments of the loan being serviced (see Rosenblatt [1994]). On the positive side, a servicer earns significant prepayment float income by investing