Managing prepayment float.

Author:Johnson, Gerard F.
Position:Mortgage prepayments

The servicing portfolio was not the only thing that suffered from prepayments last year. The stiff interest expense tied to prepayments in various MBS pools also hit mortgage bankers in the pocketbook. But there are ways to minimize this risk, and lenders now understand the need to control this potentially big expense item.

FOR MOST SERVICERS, LAST YEAR'S ONSLAUGHT of mortgage prepayments was accompanied by an unusually high amount of prepayment interest expense. But there are ways mortgage bankers can manage this exposure if they take some time to study a few important details tied to the choices they make in selling loans into secondary market securities.

The amount of prepayment interest risk is determined by the agency that the loan is sold to, as well as the product selection. In last year's rapid prepayment environment, which has prompted mounting prepayment interest expenses for many, the choice of secondary market agency and loan program finally is receiving greater scrutiny.

There are many questions that have been raised by this growing expense item. Mortgage bankers understandably want to know why the interest expense on Fannie Mae MBS is so high. Can it be avoided? Is the interest rate risk upon prepayment considered when the secondary marketing choice is being made between a Freddie Mac PC and a Fannie Mae MBS and what is the impact of prepayment float on PC/MBS prices? The answers to these questions depend on a variety of conditions.

The primary considerations in selecting loan purchase commitments from Freddie Mac and Fannie Mae are the daily market PC/MBS prices and each institution's guarantor fees. Two other factors affect the market price. The investor's payment date, or the number of days that the agency holds the funds before remitting to the security investor, is one factor. The prepayment remittance float benefit enjoyed by the servicer is the other. Each one of these factors can be quantified individually to determine its impact on the security price.

This article will review and compare only the prepayment float differences of the two secondary market agencies. It also will determine the float impact on PC\MBS prices and offer suggestions on how to manage the prepayment interest rate risk.

To keep the comparison simple, only the Freddie Mac Gold PC (Advance Remittance Cycle) and the Fannie Mae MBS program will be evaluated. Both agencies have other programs that feature different float benefits, remittance periods and pricing criteria. However, these two products are the most popular and epitomize the agencies' approach and philosophy toward prepayment interest risk.

Prepayment remittances

Although it appears to be a small factor in price, the prepayment remittance schedules of the two agencies involve critical servicing risks that can sour the overall profitability of originating and servicing a mortgage loan. Most mortgage bankers look to servicing cash flows to recapture costs associated with loan origination. These cash flows depend on the collection of fees over the life of the loan.

On a profit-per-loan basis, a prepayment (especially in the first three years) does not provide mortgage bankers with the opportunity to capture all of their origination costs. If this prepayment is tagged with an additional net interest expense on the prepayment, the profitability of the loan is seriously jeopardized.

It is important to understand what factors affect the amount of float benefit received or paid on mortgage loan prepayments.

Measuring prepayment risk is inherently difficult because it is impossible to accurately predict exactly when a loan will pay off and the condition of the interest rate cycle at that time. However, assumptions can be made about the future direction of interest rates and the interest rate cycle, and the prepayment outcome can be shown given specific interest rate scenarios. These illustrations will provide a better picture of the prepayment interest rate risk and the potential for net interest expense when a loan pays off.

Freddie Mac Gold PC (ARC)

Freddie Mac has a standard prepayment remittance cycle for all its products. The servicer is required to remit the prepaid principal and the accrued interest (required net yield) five business days (seven calendar days) after the prepayment is received. The servicer is guaranteed seven days' float.

The Freddie Mac Gold PC (ARC) float benefit on prepayment remittances is constant. The program provides a potential of seven days' float at the short-term investment rate. There may be additional servicing costs for off-cycle prepayment remittances. However, the amount of additional cost, if any, should be negligible.

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