Encyclopedia of Financial Models III

Prepayments and Factors Influencing the Return of Principal for Residential Mortgage-Backed Securities

WILLIAM S. BERLINER

Executive Vice President, Manhattan Advisory Services Inc.

FRANK J. FABOZZI, PhD, CFA, CPA

Professor of Finance, EDHEC Business School

ANAND K. BHATTACHARYA, PhD

Professor of Finance Practice, Department of Finance, W. P. Carey School of Business, Arizona State University

Abstract: Prepayments and their impact on principal cash flows are critical components of the valuation, trading, and risk management of residential mortgage-backed securities. Because of this, substantial resources are expended by investors and dealers in understanding and modeling prepayment “speeds.” However, prepayment behavior is not static and has evolved repeatedly since the first prepayment waves in the early 1990s. Moreover, the very definition of “prepayments” has evolved from one focused primarily on borrowers’ refinancing options to one encompassing a plethora of actions and decisions.

In general, a mortgage is a loan that is secured by underlying assets that can be repossessed in the event of default. In the residential housing market, a mortgage is defined as a loan made to the owner of a one- to four-family residential dwelling and secured by the underlying property (i.e., the land, the structure and any improvements). The fundamental unit in the residential mortgage-backed securities (MBS) market is the pool. At its lowest common denominator, mortgage-backed pools are aggregations ...