Question

. Please name and describe in details the three sources of prepayment in the mortgage market.

Answer 1

Prepayment Sources or models

A) Early static Prepayment Model- At one time, the standard approach to Prepayment modeling was to assume that all mortgage prepayments occurred in year 12. This assumption was based on Federal Housing Administration (FHA) data that showed on average that mortgage terminated in twelfth year. This method used rarely now; becauseit clearly produces unrealistic and unreliable results. So Public securities association adopted PSA model; this assumes increasing prepayment rates for the first 30 months and then constant prepayment rates afterwards.

The standard model, which is also referred to as 100%PSA or 100PSA assumes that prepayment rates will increase by 0.2% for the first 30months until they peak at 6% in month 30.

B ) Dynamic Prepayment Model-The need for more robust prepayment models motivated Wall Street to develop more sophisticated models that project prepayment rates as a function of both Interest and non Interest related variables.

For the most part, these statistics models use regression techniques to identify variables that affect prepayment behaviour.

Although the specific variables in these models can vary considerably there is general agreement that three factors appear to drive prepayments

I)The prevailing mortgage rate relative to the coupon.

ii)The characteristics of the mortgage (i.e. size of the loan, location of the property)

iii) time of the year

C)OTS Prepayment Model-For better understanding , how prepayment models work, need to understand OTS NPV model.

The NPV model currently uses a three factor pre model in conjunction with a Monte Carlo process that generates 200 rate paths to solve for the OTS( The mortgage rate simulated during the Monte model are the age of the mortgage, the time of the year and interest incentive)

OTS model is able to predict the future level of mortgage prepayment rates. This is indeed a critical improvement over static prepayment models.