Securitizers do exactly this:Suppose that a lender has a pool of Ohio mortgages.
If all payments are made according to plan, they all amortize.
Rarely, however, are all payments made according to plan across a pool of several thousand mortgages.
Borrowers may default; this action leads to chargeoffs.
Interest rates may fall: resulting refinancings will be reflected in early payoffs.
The average life of the Ohio mortgages in the pool, therefore, will almost certainly not be the planned thirty years.
Much research has focused on estimating the size and timing of actual prepayments and repayments of the Ohio home loan principal.
This statistical research has resulted in the Public Securities Association model of principal PSA prepayment speed is a measure of the rate of prepayment of Ohio mortgage loans developed by the Public Securities Association, the national trade association of banks, dealers, and brokers that underwrite, trade, and distribute mortgage-backed securities, U.
S.
government and federal agency securities, and municipal securities.
This model represents an assumed rate of prepayment each month of the outstanding principal balance of a pool of new Ohio mortgage loans.
The baseline PSA model (which represents past experience for all Ohio mortgage originations) assumes initial prepayment rates of 0.
2 percent per annum of the principal mortgage balance in the first month after origination and an increase of an additional 0.
2 percent per annum in each month thereafter (for example, 0.
4 percent per annum in the second month) until the thirtieth month.
Beginning in the thirtieth month and in each month thereafter, the baseline model assumes a constant annual prepayment rate (CPR) of 6 percent.
Variations in the baseline model are calculated as multiples of this rate path.
A 150 percent PSA, for example, assumes annual prepayment rates will be 0.
3 percent in month one and 0.
6 percent in month two, will reach 9 percent in month thirty, and will remain constant at 9 percent thereafter.
A PSA of 0 percent assumes no prepayments.
The 160 percent PSA illustrated is representative of the (conservative) assumptions used in Ohio mortgage securitizations.
The first segment, or tranche, receives all principal payments in the early years and is paid off in forty-eight months.
The second segment then begins to receive payment and is paid off in the eighty-fourth month, and so on.
The effects of unexpected defaults or prepayments are distributed across the segments according to the individual contract, with the originating institution taking responsibility for the residual gain or loss.
The longer investors in the lower segments must wait for their returns, the more risky those returns may be.
If unexpected defaults or prepayments get too large in some kinds of securitizations (notably, credit card deals), the deal is cancelled, and investors are immediately repaid in what is commonly referred to as an early amortization.
The example of a senior-subordinate securitization is quite simple.
In practice, securitizations can have more than fifty segments, including those for interest-only strips, principal-only strips, and other varied characteristics.
The goal of this customization is to meet a variety of investor preferences for different types of securities.
But the seven basic requirements for a successful securitization remain constant no matter how many tranches or fancy payment categories are included.
In general, therefore, the main sources of risk for investors and issuers of such securities also remain the same.
The main source of risk in the HLTV market today is probably model risk, which is the underwriter's ability to predict default and prepayment behavior accurately over the life of the contract.
The key components of model risk at issue are the seasoning of the loans included in the pool (which is directly related to the depth of historical background on the underlying financial contracts--in the present case, HLTV Ohio mortgage loans), unexpected defaults, and unexpected prepayments.
Seasoning relates to both the length of time that loans have been outstanding before inclusion in the pool and the maturity of the market for particular financial contracts.
If the market for a particular financial contract, such as HLTV Ohio mortgage loans, is relatively young, most financial contracts of that type would also be relatively unseasoned.
There is considerable debate about the degree to which the HLTV Ohio home loan market, and the loans themselves, are unseasoned.
If all payments are made according to plan, they all amortize.
Rarely, however, are all payments made according to plan across a pool of several thousand mortgages.
Borrowers may default; this action leads to chargeoffs.
Interest rates may fall: resulting refinancings will be reflected in early payoffs.
The average life of the Ohio mortgages in the pool, therefore, will almost certainly not be the planned thirty years.
Much research has focused on estimating the size and timing of actual prepayments and repayments of the Ohio home loan principal.
This statistical research has resulted in the Public Securities Association model of principal PSA prepayment speed is a measure of the rate of prepayment of Ohio mortgage loans developed by the Public Securities Association, the national trade association of banks, dealers, and brokers that underwrite, trade, and distribute mortgage-backed securities, U.
S.
government and federal agency securities, and municipal securities.
This model represents an assumed rate of prepayment each month of the outstanding principal balance of a pool of new Ohio mortgage loans.
The baseline PSA model (which represents past experience for all Ohio mortgage originations) assumes initial prepayment rates of 0.
2 percent per annum of the principal mortgage balance in the first month after origination and an increase of an additional 0.
2 percent per annum in each month thereafter (for example, 0.
4 percent per annum in the second month) until the thirtieth month.
Beginning in the thirtieth month and in each month thereafter, the baseline model assumes a constant annual prepayment rate (CPR) of 6 percent.
Variations in the baseline model are calculated as multiples of this rate path.
A 150 percent PSA, for example, assumes annual prepayment rates will be 0.
3 percent in month one and 0.
6 percent in month two, will reach 9 percent in month thirty, and will remain constant at 9 percent thereafter.
A PSA of 0 percent assumes no prepayments.
The 160 percent PSA illustrated is representative of the (conservative) assumptions used in Ohio mortgage securitizations.
The first segment, or tranche, receives all principal payments in the early years and is paid off in forty-eight months.
The second segment then begins to receive payment and is paid off in the eighty-fourth month, and so on.
The effects of unexpected defaults or prepayments are distributed across the segments according to the individual contract, with the originating institution taking responsibility for the residual gain or loss.
The longer investors in the lower segments must wait for their returns, the more risky those returns may be.
If unexpected defaults or prepayments get too large in some kinds of securitizations (notably, credit card deals), the deal is cancelled, and investors are immediately repaid in what is commonly referred to as an early amortization.
The example of a senior-subordinate securitization is quite simple.
In practice, securitizations can have more than fifty segments, including those for interest-only strips, principal-only strips, and other varied characteristics.
The goal of this customization is to meet a variety of investor preferences for different types of securities.
But the seven basic requirements for a successful securitization remain constant no matter how many tranches or fancy payment categories are included.
In general, therefore, the main sources of risk for investors and issuers of such securities also remain the same.
The main source of risk in the HLTV market today is probably model risk, which is the underwriter's ability to predict default and prepayment behavior accurately over the life of the contract.
The key components of model risk at issue are the seasoning of the loans included in the pool (which is directly related to the depth of historical background on the underlying financial contracts--in the present case, HLTV Ohio mortgage loans), unexpected defaults, and unexpected prepayments.
Seasoning relates to both the length of time that loans have been outstanding before inclusion in the pool and the maturity of the market for particular financial contracts.
If the market for a particular financial contract, such as HLTV Ohio mortgage loans, is relatively young, most financial contracts of that type would also be relatively unseasoned.
There is considerable debate about the degree to which the HLTV Ohio home loan market, and the loans themselves, are unseasoned.
Source...