Federal Home Loan Banks of San Francisco & Chicago choose Applied Financial Technology, Inc.’s Espiel Prepayment Model

San Francisco - If you own a home with a mortgage, when you acquired your mortgage you also acquired two options...the option to default (stop paying) on your mortgage, and the option to prepay your mortgage.

The option to default on a mortgage is exercised as infrequently as possible due to the negative consequences to the consumer's credit rating, and only if the outstanding loan is higher than the value of the home. But, unless a borrower has a prepayment penalty attached to their loan, the option to prepay a mortgage may be exercised without any negative consequences to the consumer at any time, and is a function of one of two changes in a consumer's world: the desire or need to move, or a lowering of mortgage rates below that which the consumer currently pays on their mortgage.

Currently, the option to default on a mortgage is fully built in to the price of the mortgage. In other words, if a consumer has a high probability of default, the mortgage rate that they must pay on their mortgage is higher than a consumer with a lower probability of default. This higher rate provides the lender with additional cashflows to "hedge" against the probability of a default. Due to the availability of simple methods of measuring default risk (FICO Scores) it is easy for the lender to include this risk in the pricing. This measurement of "default risk" is also used by banks that service loans, in the secondary market when buying and selling loans, by investment banks that may securitize the loans, and by investors in whole loans and mortgage-backed securities.

On the other hand, the option to prepay is NOT easy to measure and is not currently included in the rate that consumers must pay when they take out a mortgage. Or, if it is, it is spread equally across all borrowers no matter what their specific "prepayment risk". A software company in San Francisco is looking to change that. This fall Applied Financial Technology will be offering the Espiel Score for Prepayments (ESP) to all participants in the mortgage lending industry. The Score will utilize additional information provided by lenders about specific borrowers or loans to provide Prepayment Scores, and will enable the lenders to include the risk of prepayment in their pricing to borrowers. Additionally, the Scores may be used as a new language of communication between lenders, servicers and investors. The Score provides a simple method of comparing the underlying prepayment risk of externally similar loans, whether it is for valuation, customer retention or hedging purposes. The Scores will be provided free via a website.

Historically, valuing the prepayment option has been a difficult task. But, since the value of the option to prepay is worth, on average, ten times the value of the option to default, it is important to participants in the industry to define it as accurately as possible. In the $4 trillion Mortgage-backed securities market alone, a small mistake is in all probability worth over $30 billion.

An interesting consequence of including the ESP Score in mortgage loan pricing could be increased interest from lenders in credit-impaired borrowers. The credit-impaired borrower often brings to a lender less risk of prepaying a loan. So, once prepayment risk is included in the pricing calculation, the credit-impaired borrower becomes much more attractive to all lenders. As a result, rates provided to borrowers with less than perfect credit may be as low as, or lower than, prime credit borrowers. This effect could open up even more opportunities for additional consumers to enter the home-buying market and, at the same time, eliminate many of the industry problems with predatory lending, since more lenders will compete for credit-impaired borrowers.

One thing that Applied Financial Technology is keeping a close eye on is Congressional, SEC and OFHEO interest in promoting improved protection for investors and greater efficiency in the MBS markets by asking Fannie Mae and Freddie Mac to release more detailed data about the underlying loans in their mortgage-backed securities. This data would be extremely helpful in providing ESP Scores on the loans underlying mortgage-backed securities and would therefore help reduce the overall prepayment risk to the industry while providing impetus to the incorporation of prepayment risk in loan valuation, thereby expanding opportunities for home ownership.