'Prepayment Score' Joins Credit Score as New Tool
Lenders have long relied upon credit scores to assess the default risk of individual borrowers, and now one expert in prepayment modeling has created a score to assess a borrower's propensity to prepay.
Michael Bykhovsky, head of Applied Financial Technology here, said a couple of mortgage lenders are already using the system.
He says the option to prepay, which can wipe a lender's mortgage servicing asset off the balance sheet, costs lenders 10 times as much as the risk of default. Specifically, he says that on average, the default option is worth between three and 10 basis points per year for a loan, while the refinancing option is worth 30 to 100 basis points.
"When you read about companies going bankrupt in the mortgage industry in the last 10 years, it has never been about defaults. It has been about prepayments," Mr. Bykhovsky noted.
Typically, prepayment models focus on average characteristics for a given type of loan and are useful in portfolio analysis, but Mr. Bykhovsky's scoring system seeks to assess the difference in the propensity to refinance between different borrowers with the same loan. For example, two borrowers with a given loan type and interest rate on loans originated in a specific year might have different behavior patterns when it comes to refinancing the loan or prepaying the loan because of a move.
The new model creates individual scores based on over 20 criteria about the loan, including origination year, geography, household characteristics, income, loan-to-value ratio, and past prepayment behavior. Those characteristics are used to modify standard prepayment models for the individual scores.
He believes that individual prepayment scores could change loan pricing, in the way that credit scores have enabled "risk-based" pricing based on default risk. Today, borrowers with a high propensity to prepay their loans are not paying any more for that option than borrowers who are less likely to refinance.
Currently, the average "mistake" in evaluating prepayment risk costs lenders about 15 basis points per loan, or $50 billion annually on an industrywide basis.
"Basically, people with larger loans and better credit characteristics are getting a free ride," Mr. Bykhovsky told MSN.
In addition, the scores can be used to manage hedging decisions, he said.
The prepayment score is actually two scores, a refinancing propensity score and a propensity to move score.
It's not the first time someone has tried to create a prepayment score. At least one previous effort by a company that has gone out of business failed, Mr. Bykhovsky acknowledges.
He says that previous prepayment scores did not measure the propensity to refinance, however, rather focusing a prepayment risk at a given interest rate level that quickly became irrelevant when rates changed.
"We are not associating the score with the probability of prepayment, but with the propensity to refinance," Mr. Bykhovsky said.
His company has applied for a patent on the technology for the prepayment scores.
Currently, he said Applied Financial is working with a couple of large institutions that are implementing the prepayment scoring technology. But he said those lenders do not presently want their names released.
"At this point, they are very busy cherry picking the loans," he said.
Mr. Bykhovsky says that today, borrowers with a high propensity to refinance pay no more than lower risk customers.
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