The AFT Score:

Successfully Adopted by Mortgage Industry

Forecasting prepayment of mortgages given any set of interest rates is the single most important consideration in valuing mortgage cash flows. Yet mortgage assets are priced incorrectly because of the inability to understand prepayment propensity at the loan level. Pool-level data, which includes indicatives such as weighted average coupon, weighted average maturity, loan type and original term provide – at best – a limited scope of information.

Loan-level prepayment forecasting with the AFT SCORE provides a far more precise strategy to price, fund and hedge mortgages, which can dramatically improve returns and create sustainable competitive advantage. AFT has created a modifier as a function of loan-level data employing pool-level prepayment vectors. The modifier is in the form of a score, deployable in current analytic systems, which allows market participants to understand the value of individual loans.

Not all loans in a mortgage pool will prepay exactly as the pool prepays. Loans, having either more or less value than the pool's average, require different pricing, funding, and hedging than the pool's average does. A subset of a loan pool will always prepay differently from other subsets. And so the opportunity for better performance lies in identifying and uncovering these sub-pools to understand how they will perform.

The prepayment SCORE, which is both a housing turnover score and a refinancing score, can be made accessible to interface with analytic systems, and AFT has also created tables that provide relative value, duration and short-term prepayment projections as part of its overall prepayment scoring functionality. These tables are available over the web. Licensed visitors to the site can indicate any coupon, weighted average coupon and loan type that is traded in the market and view the score results.

Narin Seera, Senior Vice President of Risk Management at First Horizon-Home Loans, recognizes that with the wide variety of mortgages and mortgage types, his organization needed to focus on prepayment measurement to segregate its portfolio into sub-pools upon which First Horizon could take actionable steps.

“Prepayment valuation is a key risk factor for mortgage lenders,” said Mr. Seera, “and will continue to be the case going forward. It’s critical for us to both understand and act on our prepayment measurements, based on a score of data that is as accurate, complete and reliable as possible.”

AFT’s loan level prepayment score was created with loan-level data and prepayment histories obtained from various top lenders and servicing data aggregators at the loan's origination. The AFT SCORE considers prepayment variables such as original loan amount, loan-to-value ratio, geographic location, loan purpose and borrower credit. The combined effect generates a highly precise score indicating the propensity to prepay. AFT SCORE can be produced against all mortgage product types including prime, subprime, hybrid and Alt-A.

The question a score needs to answer is which loans with the same coupon and origination date are the most likely to prepay first. Prepayments are driven largely by the difference between a mortgage coupon and the current mortgage rate, and so a score showing that a 9% mortgage is more likely to prepay than a 7% mortgage in a 6% rate environment is not worth much.

The prepayment score must differentiate between instruments the market would otherwise view as similar or the same for that score to hold value. The AFT SCORE is also predictive over time. A loan in the most likely to prepay category will always have a higher propensity to prepay regardless of interest rates.

“We deal with a very large and at times unpredictable marketplace where differentiating between mortgages is not always intuitive on its face,” Mr. Seera said. “AFT’s risk management methods help not only to identify trends, but to actively take steps to manage the inherent, though not always known, risks as those trends are uncovered, and based on loan level data, which increases accuracy considerably. That gives us knowledge we can use.”

Forecasting short-term prepayments as a function of the prepayment model can also be accomplished through analysis, enabling insight into each loan’s single monthly mortality. Such understanding could be used to rank short-term prepayment propensity to solicit loans that would be unlikely to refinance.

The implications can be dramatic: A mortgage servicer that would like to retain borrowers that might refinance could prioritize marketing efforts based on each loan's relative propensity to prepay. A top servicer/originator in the US used the AFT SCORE for a retention campaign with a net income increase of 67%.

The value of the AFT SCORE is its ability to better differentiate prepayments relative to a standard prepayment model or any currently used method of organizing portfolio retention efforts. AFT scored 169,652 loans for the first quarter of 2003 for this major servicer/originator. The loans were bucketed into ten equal deciles. The actual single monthly mortality of loans paying off (20,419) was exceedingly close to that projected, and the ranking of the loans was perfect.

Without AFT’s SCORE, only 15% of the loans indicated they were most likely to prepay. With the AFT SCORE 23% of the loans showed that short-term propensity. An additional 1,287 loans identified by the AFT SCORE improved the servicer’s net income results over 67% for one decile. The AFT scoring can be reused in the next campaign because the relative rankings do not change. Moreover, the AFT SCORE will add value when the servicer/originator solicits any of the other deciles.

First-Horizon’s Seera is planning to use this prepayment scoring model in an innovative way – to collect stale late fees. “The plan is to target the loans that have a very low propensity to prepay with an offer for the borrower to send in a discounted late fee,” he said. The discount is based on the value of the uncollected late fee derived from the average life of the loan as projected by AFT’s prepayment score.

To obtain AFT’s prepayment SCORE an AFT ftp site accepts files containing thousands of loans and returns scores within an hour of submission, while AFT’s web site accepts indicatives as they are entered and returns scores instantaneously.

“AFT has provided several ways to access and benefit from its scoring technology,” said Mr. Seera. “This enables us to obtain actionable information in ways that best suits our own organizational processes.”