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CFA Fixed Income: Mortgage Backed Securities: Part 2

October 31, 2013
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This is an extension of our blog on Mortgage Backed Securities and It’s Pricing

Loan-level variables reflect borrower’s characteristics to a great extent. For example, it has been seen that a borrower with high FICO score having high loan-to-value ratio has high probability of early prepayment while loan with same loan-to-value but with a low FICO score borrower will have low probability of prepayment. In fact these loans will have high probability of default.

Macro-economic variables also influence prepayments. If 10-year interest rate, proxy for mortgage rate, then there will be high probability of prepayment because in this kind of environment, borrower is likely to be able to refinance his/her loan at lower rate.

Derived variables can sometimes explain prepayment behavior more accurately because they can capture interaction among various base-variables. For example, SATO is indicative of creditably of a borrower. High coupon gap, for example, indicates higher refinance incentive and hence, indicates higher chances of prepayment.

Following are some audit charts based on historical performance of some fixed-rate mortgage-pools . Audit charts are commonly used as a guiding tool to select variables for the prepayment model.

#CFA Fixed Income

Higher LTV indicates that there will higher savings on interest if the loan is prepaid.

#CFA Fixed Income

Similar to LTV trend, higher remaining principal fraction indicates higher refinance incentive.

#CFA Fixed Income

Mortgages with higher coupon rate have higher probability of getting cheaper financing and hence have higher probability of prepayment.

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Trend of prepayment is counterintuitive. Usually higher FICO would indicate sounder financial health of the borrower and such loans should have higher prepayment rate, But audit chart indicates that prepayment rate decreases with FICO.


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Higher change in HPI means appreciation in property values and borrowers have cash-out incentive by prepayment loans on such properties.

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There is higher movement, job change activities in summer months leading to higher prepayment rate in those months.

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Some regions have more prepayment rates than others as indicated by the above audit chart.

Stay tuned for more!


About the Author

Ashish is a Senior Researcher in fixed income group of Research Affiliates. He was a Research Analyst at Bayview Asset Management and Lead Modeler in MBS analytics group. He has an MFE from UCLA Anderson School of Management, B.Tech from IIT Delhi, PhD from Philadelphia University.


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