Question

List and explain three methods of predicting prepayments on a pool of mortgages.

Answer 1

Methods of predicting prepayments on a pool of mortgages are:

1. Standard Mortgage Yield: The first and simplest specification is to assume the "standard mortgage yield" or "prepaid in 12." In this specification, it is assumed that there are no prepayments whatsoever until the twelfth year, when all the mortgages in the pool prepay in entirety.

This specification has the advantage of computational simplicity and conforms to the reality that the effective maturity of most mortgage pools is far shorter than the final maturity date. Beyond that, not much can be said for this assumption. It totally neglects the prepayments that occur in the early years of a mortgage pool. Therefore, a yield calculated and quoted on the basis of this "standard" prepayment assumption seriously understates the potential yield on a pass-through security trading at a deep discount and overstates the potential yield on a premium pass-through.

2. FHA Experience Method: At the other end of the spectrum is a prepayment specification based on actual experiences of the Federal Housing Administration (FHA). The FHA compiles historical data on the actual incidence of prepayment on the mortgage loans that it insures. This data covers a wide range of origination dates and coupon rates. The FHA experience method was clearly an improvement over the standard mortgage yield, since it introduced realistic and historically validated assumptions, yet it is not without its own problems. Since the FHA publishes a new series almost every year, the secondary mortgage market faced the confusing circumstance of having securities based on series from different years.

3. Constant Prepayment Rate: Another specification that has been used is the constant prepayment rate (CPR), also known as the "conditional prepayment rate." This specification assumes that the percentage of the principal balance that is prepaid during a given year is a constant. The CPR method is easier to work with analytically than FHA experience, because the applicable prepayment rate for each year is one consistent number, not one of 30 varying numbers. Consequently, it is easier to compare quoted yields for a certain holding period across different prepayment assumptions. One subtle advantage to the CPR method is that it exposes the subjective nature of the prepayment assumption. The FHA experience approach implies a degree of precision that might be totally unwarranted. A variant of the CPR is called "single-monthly mortality" (SMM). The SMM is simply the monthly analogue to the annual CPR. It assumes that the percentage of the principal balance that is prepaid during a given month is a constant.

4. PSA Standard Prepayment Model: The most commonly used prepayment rate assumption is the standard prepayment experience offered by the Public Securities Association (PSA), an industry trade group. The PSA's goal was to bring standardization to the marketplace. The first 30 months of standard prepayment experience call for a steadily rising CPR, starting at zero and rising 0.2 percent each month; thereafter, a level six percent CPR is used. Sometimes, however, yields are based on a faster or slower prepayment assumption than this standard. This change in prepayment assumption is indicated by designating a percentage above or below 100 percent.

(a). An MBS quoted at 200 percent PSA assumes a 0.4 percent CPR monthly rise over the first 30 months, then a level CPR at 12 percent.

(b). An MBS quoted at 50 percent PSA assumes a 0.1 percent monthly increase in the CPR, until the three percent CPR level is attained.