Prepayment

Summaries

Conditional Prepayment Rate (CPR)

Public Securities Association (PSA) prepayment benchmark

Single Monthly Mortality (SMM) Rate = 1 – (1-CPR)^(1/12)

Or

CPR = 1-(1-SMM)^12

SMM = 5% means 5% of the pool’s beginning-of-the-month outstanding balance (less scheduled payment) will be prepaid.

PSA:

N*0.2% CPR for the 1^st 30 months

6% CPF afterwards

150%PSA just multiply everything by 150%

SMM has physical meaning. How about CPR? Probably not?

Prepayment = SMM x(beginning balance – scheduled payment)

The following factors affect prepayment rate:

1. Spread between current and original mortgage rate

2. Mortgage path

3. Housing turnover

4. Seasoning – prepayment increases as the mortgage ages

5. Property Location

Prepayment Risk:

First, there is a normal prepayment rate

1)      Contraction risk – if the interest rate falls, there is higher prepayment rate. The bond price is capped due to prepayment (-ve convexity). Also, have to invest the prepayment at lower interest rate (re-investment risk)

2)      Extension risk – if the interest rate increases, the prepayment rate is smaller. Less prepayment making the holder missing the opportunity to re-invest in higher interest rate.

Questions:

What is refinancing burnout?

For example, if the mortgage path is such that there are several drops in the interest rate. During the first drop, the prepayment rate will be high due to refinancing. But if the interest rate raises back to normal and have a 2^nd drop (assume similar level), the prepayment rate will be much lower because those who are able to refinance would have refinanced already during the first drop. This is called refinancing burnout.