Understanding How Prepayment Affects Default, and Vice-versa
Understanding the ins and outs of competing risk models is beyond the scope of this article. However, it is important to understand how using such a technique can have very significant impacts in real-world situations. Competing risk hazard models, like traditional prepayment models, have different effects depending upon the projected economic scenario. In fact, one of their principal benefits is the ability to separate the effect of portfolio composition (static characteristics such as documentation type or original FICO score) from the effect of macro risk factors (dynamic effects driven by interest rates or housing prices).

Consider the following graphs taken from Hall and Brown (2004). This study, done by two researchers at Wells Fargo's Home Equity Group, included default and prepayment estimates from a competing risk model in a variety of "good" and "bad" future scenarios. In the first graph, a hypothetical portfolio is subjected to an increase in interest rates. The second graph shows the exact same portfolio subjected to a decline in interest rates.

The projected prepayment and default rates obviously are significantly different. In the falling rate scenario, fast prepayment rates leave many fewer opportunities for loans to default; hence, prepayment rates are high but default rates are low for the same collateral. In the rising rate scenario, however, the increased duration of the portfolio leaves more opportunity for default; hence the default rate is much higher for the same collateral.

As the following pair of graphs illustrate, changes in prepayments driven by rate effects not only affect the magnitude (cumulative defaults), but also timing (default incidence). >>>