Valuation Commentary - May '06

Value-Space Refinancing
by Alex Levin

Andrew Davidson & Co., Inc.’s upcoming 2006 Conference agenda includes many interesting topics revolving around modeling borrowers’ actions. One of them is a uniform approach to prepayment modeling and its application to hybrids and ARMs. From a practical stand-point, prepayment modelers are overwhelmed these days with the proliferation of mortgage programs, types and “enhanced” datasets. Chasing every feature such as prepay penalty size, window or allotted curtailment becomes a challenge. An even greater need for a universal model exists with new mortgage origination programs that lead to immediate securitization and trading, without any volume of available prepayment history. Prices do exist and are agreed upon between buyers and sellers, without any firm knowledge of the underlying pool’s behavior.

Sooner or later it will become apparent that discovering a universal refinancing model ranks in importance close to the Black-Scholes, just a notch below the Newton gravitation law. On a more serious note, unifying prepay models with some accuracy is not an impossible task. In fact, we know several methods of doing so, and in this article we introduce one of them–perhaps the most unexpected from a traditional MBS engineering point of view. While the format of The Pipeline calls for brevity, I hope to discuss this topic in a greater detail at our conference in June.

Refinancing Incentive

A key element of prepayment modeling– the refinancing S-curve– is normally drawn and built against a “refinancing incentive.” The latter can range from a simple rate spread (or ratio) between GWAC and a market rate to more sophisticated definition, which reflect estimated payments, remaining term and even forward-looking imitations of borrowers’ views. AD&Co. models employ an approximate payment ratio computed on the remaining WAM-matched basis. This choice is both practical and meaningful. This refinancing incentive is equal to the present value of the existing loan in the current economy assuming that only scheduled payments are made. It is not difficult to extend this measure to a borrower’s actual time horizon, to the balloon provision (if any) or to ARM rate resets. In the latter case, forward averaging of rates or payments is proven to be a useful trick. So, if the loan is a hybrid or an ARM, then an anticipated GWAC can be used instead of the actual one.

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