Prepayment Scores Could Aid Mortgage Players

HedgeWorld.com, November 28, 2005

SAN FRANCISCO (HedgeWorld.com) - A new scoring method holds the possibility of profit for large, multi-billion dollar hedge funds that are trading mortgage-backed securities.

Applied Financial Technology has developed a program that can issue scores for the likelihood of mortgage prepayment. Some traders believe there is little value in trading of prepayment risk in mortgage-backed portfolios, but Michael Bykhovsky, chief executive of AFT says they are wrong. He says that the arbitrage opportunities in trading prepayment risk far outweigh any other type of strategy in this elite segment of the fixed-income market. The profits to be found in accurately assessing prepayment risk total US$50 billion, according to his calculations.

Using his company's prepayment risk scoring methodology, Mr. Bykhovsky found there were differences of 1% to 15% between the market value and the actual economic value of agency interest-only strips, and 1% to 2% difference among agency pools.
AFT is just now beginning to market its service more widely to hedge funds, promoting prepayment risk as one of the last major arbitrage opportunities around. Comparing his business to that of an arms dealer, Mr. Bykhovsky said that while others are selling bows and arrows, he's opening up a shop selling machine guns.

For mortgage-backed players, prepayment risk has always been difficult to pinpoint. Looking at factors such as the size of the loan and where the mortgage originated has given traders nothing more than an uneducated guess in the past.

Many mortgage market participants would guess that loans originating in the bustling real estate markets in California would have the highest propensity toward refinancing. But, actually, adjusting for all other factor differences~such as loan size, loan to value ratio, purpose of the loan, FICO (Fair Isaacs Co.) credit score and residency type~mortgages coming out of Wisconsin have the highest prepayment risk.

California is only in the top 30% of states ranked by prepayment risk, which runs counter to the widely held perception that areas with the highest appreciation have the greatest refinancing propensity.

For hedge funds specializing in mortgage-backed securities derivatives, the collateralized mortgage obligation tranches, whose valuations often are sensitive to the connection between interest rates and the resulting prepayment response, the scores are particularly crucial. They make the difference between a lucrative trade and one that loses a lot of money, according to Mr. Bykhovsky.

Unlike other scoring services in the market, AFT is focused on long-term trends rather than short-term developments based on interest rate moves.

The method to create scores to aid in the decision process is a technology AFT is patenting. The scores are part of a complex algorithm that is based on a number of factors such as loan size, loan to value ratio, FICO credit score, property type, whether the loan is for a new purchase or refinancing, and geography. AFT has been around since 1996; it focused on offering prepayment risk models to banks and other institutions before rolling out the product to hedge funds.