Question:

What is the PSA prepayment model and is it the only prepayment model?

Answer:

Public Securities Association Standard Prepayment Model, or simply PSA, is a method of quantifying prepayment risk associated with a pool of mortgage loans backing a security. The model takes into account the fact that the rate of prepayments gradually changes over the lifetime of mortgage loans.

This is because prepayments mostly occur when interest rates drop, and because interest rates usually drop slowly, prepayments increase for a period of time but ultimately reach a maximum and then stay constant. The duration of the rate increasing period and the annual percentage increase of the prepayment rate depend on the underlying loan.

The PSA model assumes a linear rise in prepayments, which becomes steady after 30 months. The standard increase amount is 0.2%, so an indicator of 100% implies that the rate will increase monthly by 0.2% (the standard increase). In this way the PSA model calculates the effect of change of prepayment rate on the yield of a security.

Other Prepayment Models

There are other prepayment models as well that are used in the industry to measure risk. Some of them are briefly discussed below:

Single monthly mortality (SMM) is a common metric for mortgage-backed securities.

Single Monthly Mortality = Prepayments for the Month / Pool Balance at Beginning of Month

Conditional prepayment rate (CPR) is the annual version of SMM. Home-equity loans (HELs) and student loans are based on this model.

CPR = Annualized Rate of Monthly Prepayments / Outstanding Balance at Beginning of Period.

Monthly payment rate (MPR) is used for non-amortizing assets, and is calculated according to the following formula:

MPR = (Interest and Principal Payments Received in Month) / Outstanding Balance.

Absolute prepayment speed (ABS) method is used for auto, truck, and RV loans and leases, and is based on the following formula:

ABS = Monthly Income / Original Balance

There are many other prepayment models that are specific to certain types of Asset backed securities.

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