Prepayment Update - Sept '07

Model Adjustments in Light of the Credit Crunch
by Dan Szakallas and Sanjeeban Chatterjee

This month we will spend some time discussing the issues that have arisen in the past couple months as a result of the “credit crunch” being felt across the mortgage industry. We have been actively monitoring prepayment and default behavior to ensure that our models are still accurately forecasting this behavior, and if any tuning recommendations are needed. We will address two different issues in this article related to this research.

As lenders react to the staggering losses on subprime portfolios, one of the changes is much tighter underwriting guidelines when processing new mortgage applications. Borrowers who may have been approved for larger loans or lower rates a year ago are seeing that the amount they can borrow, even with good credit, is less than in the past. Coupling this with very modest home price appreciation over the last year (about 4.5%) has led to a steady decline in existing home sales every month since February. In less volatile market conditions, the months from February to August are when we normally see existing home sales rise. This trend was last seen in 2005 when existing home sales topped out in September at around 7.2 million units. This year, however, we have seen the numbers drop from 6.68 million units in February to 5.75 million as of July, so it seems as though the impact of the tighter underwriting guidelines is being seen. If new borrowers cannot finance the cost of purchasing a home, then houses will remain on the market. Sellers must either decide to sell the home at less than the asking or appraised value, or allow the home to remain on the market much longer than they anticipated.

In the MBS industry, the impact of this situation is causing some to revise their housing turnover models to account for the new market conditions. Models are over-predicting the rate of housing turnover, and it will most likely be a few months before the market corrects itself to return to historical averages. Version 5.2c of the AD&Co. Prepayment Model shows that over the last 3 months, the model has been slightly fast in forecasting CPR’s for the discount coupons (4.5’s to 6.0’s). The graph below shows model performance for FNMA 30 year pools for the month of July.