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Propensity Is Key to Applied Financial's Prepay Analysis

Mortgage servicers have a lot of tools to manage the credit risk inherent in their loan portfolios, but at least one expert thinks they need to know more about the prepayment risk inherent in each loan.

Applied Financial Technology, a San Francisco-based analytics firm, offers a prepayment propensity score that functions much like a credit score, only it focuses on each loan's risk of refinancing instead of defaulting. Prepay scores allow lenders to distinguish the risk between otherwise similar loans.

Michael Bykhovsky, president and CEO of AFT, said the company's prepayment propensity score identifies which loans have the highest propensity to prepay based on factors other than interest rates. With more and more loan level data becoming available, this allows lenders, servicers and investors to calculate the value of MSRs more precisely, he said. It also allows some big lenders to "cherry pick" portfolios, selling off loans with less desirable propensity characteristics.

Mr. Bykhovsky told MSN that historically the economic value associated with prepayment risk has been overlooked in the mortgage market. That stands in stark contrast to the "risk-based pricing" associated with default risk factors.

"It is a complex risk to manage and understand. Most of the bankers have been trained to deal with issues of credit and various impacts from accounting measures," he said.

In fact, Mr. Bykhovsky says that accounting rules play too large a role in the management of mortgage servicing rights.

"The accounting standards, with their impact on servicing rights, drive a lot of bad decision making," he said. "There is a total disconnect between accounting and economics when you are measuring MSRs."

Managing MSR portfolios today requires subtle evaluation skills that differ from the traditional focus on credit risk and aggregate prepayment risk, he said. Going forward, Mr. Bykhovsky believes that lenders will be under increasing pressure to analyze loan-level refinancing risk with an eye toward "rate agnostic" indicators of prepayments.

That's where his company's prepayment propensity scores come into play.

Prepayment propensities differ significantly by geography, loan size and a variety of other characteristics. Sometimes the empirical data challenge widely held assumptions about how the factors affect prepayment rates. And the trends are not always intuitive.

For instance, everyone knows that California loans prepay relatively fast given a rate incentive to do so. But once you hold loan size and other characteristics constant, California loans do not have greatest propensity for refinancing, as is widely presumed in the market.

Wisconsin, by contrast, is the state with the fastest refinancing rate as measured by AFT's prepayment score.

If lenders don't focus on a loan's inherent prepayment risk, they may find themselves at a disadvantage in the marketplace. Mr. Bykhovsky says he knows of at least one big lender, using its own proprietary technology, that sells off loans with high prepayment propensities, essentially cherry picking its own portfolio.

"The last thing they want is for people to find out what they are doing," he said.

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