Mortgage-Backed Securities: Products, Structuring, and Analytical Techniques, 2nd Edition

CHAPTER 3

Measurement of Prepayments and Defaults

It is essential for participants in the residential mortgage-backed securities market to understand the general prepayment and credit performance nomenclature. The market is characterized by the usage of a variety of terms; some terms describe general phenomena, while others are specific to certain types of loan products and assets. In this chapter, the basic terms used to characterize residential mortgage-related prepayments and losses are discussed. Note that our focus is on describing the terminology and outlining the methodologies used in calculating relevant metrics, while the determinants of prepayment and default behavior will be addressed in a later chapter.

Understanding the terms used in the market to define prepayments and default experience, as well as the methodologies used to generate these metrics, is important for the following reasons:

• Efficient risk-based pricing at the origination level.
• Evaluation of relative value within the MBS sector, as well as across the fixed income universe.
• Effective hedging and management of prepayment and credit risk exposure.
• Ex post performance attribution.

The sharp deterioration in mortgage performance that emerged in late 2006 led to the realization that prepayments and defaults often had related effects on MBS performance, even though they represent very different phenomena. As a result, new terminology has emerged to clarify the different circumstances that result in early ...