Prepayment Update - Oct '07

A Closer Look at ARM Prepayment Model Performance
by Dan Szakallas

In last month’s Pipeline issue, we discussed and recommended adjusting model turnover tuning to 0.85 for 30-year Fannie Mae,  Freddie Mac and Jumbo Prime loan types based on model performance in current market conditions.  We have continued to monitor and evaluate all models to determine if any additional adjustments need to be made during these tricky times. We focus this month on the Agency ARM models, and examine if any adjustments can help the model capture prepayment speeds in the short-term timeframe, for 1-month, 3-month, and 6-month forecasts.

In the hybrid ARM sector, tuning turnover to 0.85 is not the right approach. In the 6 month time period from March to August, we look at model performance for 3/1’s, 5/1’s and 7/1’s originated from 2005-2007 across the coupon spectrum. While the model shows steadily increasing prepayments as coupons increase, we see that actual prepayments have been essentially flat from discounts to premiums. For example, looking at FHLMC 3/1’s over the March to August time period, the average speed for the 4.75 coupon bucket was 13.40 CPR, while the average speed for the 6.75 coupon bucket was 14.30 CPR. This reflects the tightening of spreads between the 30-year and hybrid mortgage rate, which has happened for a combination of reasons. The graph on the following page illustrates the difference between the actual speeds and the model forecasts.