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Jason Vinar

U of MN

Spring 2011

Goals

Our goal is to build a prepayment model that we can use to dynamically in scenario, total return, and dynamic analysis of mortgage backed securities We will ﬁrst look at some historical data in the context of drivers of prepayment behaviour This will help us deﬁne a model speciﬁcation that we will use to ﬁt model to actual data In our examination of the historical data we will note several problems in using the historical data directly Lastly, we will proceed to ﬁt a prepayment model as a case study in class

individuals make prepayment decisions Changes in prepayments can drastically change the value of the security Knowledge of historical prepayment drivers is key to forecasting future prepayments Prepayment comes from turnover. reﬁnancing.The Importance of Prepayment Modelling Prepayments are the primary distinguishing feature of MBS Understanding and forecasting prepayments is critical to the analysis of MBS There is a very important link in the performance of loans and in turn the performance of the pass though or CMO. default. i. and curtailments or partial prepayments .e.

i. in agency mortgages the full principal is returned to the investor. divorce. divorce.e. and lost equity . the investor is protected against credit risk Since this component has been small historically it is often not modelled directly Increasingly it is being separated and estimated using loan level data Drivers are unemployment. however. growing families Default or Involuntary Prepayment Technically not a prepayment.Sources of Prepayment Moving or Turnover Some FHA/VA mortgages are assumable. which mitigates turnover Factors that drive this are job changes marriage.

Sources of Prepayment. cont. Reﬁnancing Largest and most variable component of Prepayments Rate/Term Reﬁnancing: In low rate environments borrowers opt to reﬁnance to lower their payment Cash-out Reﬁnancing: Borrowers ﬁnance more than they owe on the existing loan and receive the balance in cash at closing There is a cost (both time and money) associated with this which causes each borrower to behave diﬀerently given the same economic condition Curtailment is a partial prepayment of a loan and is often not modelled .

e.g. increasingly loan level data is becoming available Range of coupons is narrow.Prepayment Data Early models were based purely on the borrowers’ option and overstated prepayments Quickly researchers noted that borrowers acted ineﬃciently and adapted to model this Pool level data is easy to obtain as it is a by-product of trading activity. when rates are at 5 Age and coupon are the two most important factors recall the PSA curve the coupon is compared to the current available rate .

some February.Historical Data Fannie Mae. We can assume the WAC is 50bps higher than the pass through rate. ﬁxed rate loans originated in 2000. etc. Prepayments are separated for 5 pass through rates. Recall that the ﬁnancial crisis started in late 2007. Since some loans we originated in January. . The 10-year US treasury yield for the current month (and lagged by 2 months) is included. 30 year. All data goes through December 2009. it will be diﬃcult to get a good age ramping eﬀect.

prepayment starts low. and then level oﬀ Burnout (BO).Analyzing Prepayments By close examination of the data we can see the behaviour we expected Reﬁnance incentives (RI) relative to current mortgage rates Age ramp. people are more likely to move in the summer Given the data we will construct a prepayment model using the following functional form as a guide SMM = SMMAGE · SEASONALITY + BO · SMMRI . increase. remaining loans are not as responsive to low rates Lagged response to interest rate lows Seasonality.

. Diﬀerence. The last two calculations are used most often in loan level models not pool level models. Below is a list of several approaches. Economic value. RI = WAC − M Ratio.Reﬁnance Incentive Calculations The REFINANCE INCENTIVE (RI ) is a way to measure the money-ness of the borrower in terms of their current mortgage rate to the rate available in the market. We are going to use the 10-year semi-annual yield as a proxy for the current MORTGAGE RATE (M). There is no right way to measure the reﬁnance incentive. RI = Cold − Cnew where Cold is the borrower’s current monthly payment and Cnew is the borrower’s new payment given the market interest rates and terms. estimate of payment savings less the reﬁnancing cost over a certain time period. RI = WAC M Payment change.

It also shows 4 time segments of the data to help examine the eﬀect of the ﬁnancial crisis. This curve is commonly referred to as the ”S-Curve”.Reﬁnance Incentive or S-Curve When rates are low relative to the borrowers mortgage rate they reﬁnance The reﬁnance incentive here is using the diﬀerence calculation. SMMRI = θ1 + θ2 · atan(θ3 + θ4 RI ) . The arctangent function does a good job of ﬁtting the s-shape pattern of the reﬁnance incentive curve.

1 30 Burnout is the dampening of the reﬁnance incentive and occurs for various reasons. SMMAGE = SMMLT min WALA . BO = f (WALA) . due costs associated with home purchase. We are going to focus on the latter and make burnout be a function of the loan age (WALA). borrowers who recently purchased a home are less likely to sell the home in the near term. Another possibility is borrowers who missed initial reﬁnance opportunities are likely to miss subsequent ones. This happened following the ﬁnancial crisis.Additional Prepayment Factors Age (seasoning). Available mortgage credit could be low. They are content with the mortgage rate they have and simply will not reﬁnance. Like the PSA function we will use an age ramp that starts at 0 (corresponding to WALA = 0) and then ramps up to a long term turnover level (SMMLT ) level at WALA = 30.

it is common to lag the reference mortgage rate by 2 months.14 1. in colder climates people prefer to ”house shop” and move in the warmer months.92 0.01 1.Additional Prepayment Factors. The table below shows seasonality factors by month.07 1.99 1.72 1. Additionally. Time Lag is the eﬀect that prepayments spike about 2 months after the reﬁnance incentive is in the money. This occurs because of the time that it takes to apply for and close the new mortgage loan.22 Jul Aug Sep Oct Nov Dec 1. Seasonality.83 . housing turnover is more frequent in the summer months primarily corresponding to the school year.19 0.18 1. Jan Feb Mar Apr May Jun 0.66 0. To model this.07 0. cont.

capture the biggest drivers using the fewest parameters More complex models tend to ﬁt the historical data extremely well. making the prepayment data irrelevant going forward.Prepayment Models ”Investing based on prepayment models is a little like driving while looking through the rear view mirror. and the desire to better estimate current prices we are going to use forward projections from a market accepted model to build our model. but it is better than driving with your eyes closed. In this approach. we are assuming that the model provider has accurately accounted for historical prepayments levels that are not likely to occur given the current economic outlook. good in a variety of conditions Parsimonious. but perform poorly in forward projections Given both the ﬁnancial crisis. . It may be hard to stay on the road.” Davidson Primarily derived from historical experience no matter how simple or complex Usually they are estimated statistically Diﬃcult to predict behaviour of changing products in a changing world Strive to create a robust and parsimonious model Robust.

Review the Prepayment Model The prepayment model that we will implement has the following functional form SMMt = SMMLT min t . This allows us to constrain the parameters so that 0 ≤ SMM ≤ 1. The burnout parameter is omitted as it is both diﬃcult to estimate and implement. For the purposes of this class it is most important to have the correct reﬁnance and age relationships. This leaves SMMt = θ1 + θ2 atan(θ3 + RI θ4 ) . In our estimation with we only focus on the reﬁnance incentive which gives us the ability to add our own view of long term SMM for turnover. 1 · SF (m) + θ1 + θ2 atan(θ3 + RI θ4 )) 30 where t is the WALA. The data used in the analysis has been seasonally adjusted as well so we can ignore that term as well. The seasonality factor (SF) will be applied for the given month of the forecast. The θ parameters deﬁne the shape of the S-curve. To ﬁnd the parameters for the model we will use fmincon in Matlab.

Parameter Constraints The atan function approaches −π/2 when x → −∞ and approaches π/2 when x → ∞. This implies that −θ1 + θ2 π 2 π θ1 + θ2 2 ≤ 0 ≤ 1 Using constraints in Matlab we need to deﬁne A and b such that Aθ ≤ b. -1 1 0 0 π/2 π/2 0 0 0 0 0 0 0 0 0 0 0 1 0 0 A = b = .

Initial Guess It is good practice to analyze the functional forms for an intelligent initial guess. At the very least it will speed up the optimization routine and likely improve your results. .

cont.Initial Guess. we can make an informed guess for θ5 . Looking at the S-curve. From the work for the constraints we already know that θ1 − θ2 and π = min(SMM) 2 π = max(SMM) 2 Solving these two equations for θ1 and θ2 we get θ1 + θ2 θ1 = and θ2 = max(SMM) + min(SMM) 2 max(SMM) − min(SMM) π . This occurs for aged pass through securities and is clearly seen when there is no incentive to reﬁnance and is just min(SMM). the long term SMM from turn over.

.In-Class Exercise Analyze the prepayment function in the context of the S-curve to ﬁnd an initial guess for θ3 .

With a little algebra θ3 = tan SMMRI =0 − θ1 θ2 Lastly. We can use the y-intercept to help us ﬁnd a guess for θ3 . . set RI = 0 and use our initial guesses for θ1 and θ2 .e. i. A reasonable starting point is θ4 = 100.Initial Guess. Higher values for θ4 provide a steeper curve and more sensitivity. cont. θ4 determines the slope of the curve or sensitivity of the borrowers for small changes in rates. An accurate method to ﬁnd θ4 is to ﬁnd the maximum slope of the S-Curve data and analytically do the same using the 1st and 2nd derivative of the prepayment function.

we can look at the data to determine a reasonable level. . Recall that turnover is a steady state prepayment level that exists with and without the rate reﬁnance incentive.Fitting the Data to the Model Since we are only estimating the reﬁnance incentive parameters we need to ﬁrst remove SMM due to turnover. Therefore.

Lastly. we want to add back our age ramp with the steady state turnover. However. Therefore. 1 · SF (m) + θ1 + θ2 atan(θ3 + RI θ4 )) 30 . many prepayment modellers have done this work and have found the parameters to be pretty consistent over time. As we use the model we can vary this parameter based on our view of future home sales. Together with the reﬁnance incentive parameters we just estimated our ﬁnal model is SMMt = SMMLT min t .Adding Age and Seasonality in Future Projections As a matter of application we want to add the seasonality factor into the model. we can use the factors provided earlier. Given the right data we could estimate parameters like the ones shown earlier.

Plot the observed. and reﬁnance incentive. total return. d. Provide parameter estimates for θ and compute the sum of squared errors N sse = i=1 (SMMi − SMMi )2 where SMMi is the predicted value and SMMi is the observed data net of long term turnover. Create a Matlab function that returns the predicted SMM using the functional form that contains the age ramp. seasonality factor. and predicted SMM. and dynamic analysis with the following functional form: t . c. 1 · SF (m) + θ1 + θ2 atan(θ3 + RI θ4 )) SMMt = SMMLT min 30 Observed data to use in the estimation is on the class website. θ) . The function should have a signature similar to SMM = f (WALA. a. RI . observed net of turnover. SMML T .Homework Problem #3 Create a prepayment model that can be used later in our scenario. Choose a long term turnover level and net it from the prepayment S-curve b.

Wiley. A. . and Ching.. New Jersey.References Davidson. A... Sanders.. A. Securitization: Structuring and Investment Analysis. L. (2003). Hoboken. Wolﬀ.

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