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Answer: Defaults are increasing.
## Explanation **B is correct.** The economic conditions described in the scenario are conducive to increasing consumer defaults: - **High unemployment** (+2%) reduces borrowers' ability to make mortgage payments - **Equity market decline** (-20%) reduces household wealth and financial stability - **High interest rates** make refinancing unattractive - **Stable housing demand** suggests no external factors driving voluntary moves For agency-backed MBS, defaults are treated as prepayments because the principal payoff will be made whole by the backing agency (Fannie Mae, Freddie Mac, etc.). When borrowers default, the agency guarantees the principal repayment, effectively creating a prepayment event. **Why other options are incorrect:** **A. Curtailments are increasing.** - Curtailments (early partial repayments) typically occur when loans are older and balances are low, not with recently issued mortgages where balances are still high. **C. More properties are being refinanced.** - Refinancing is unlikely in this scenario because interest rates are high and not changing, making refinancing unattractive. Refinancing typically increases when rates decline. **D. Turnover is decreasing.** - Lower turnover would actually result in fewer prepayments, not more. Turnover occurs when people sell their homes and prepay mortgages, so decreasing turnover would reduce prepayments.
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A model risk manager is reviewing the output from a prepayment model for a portfolio of recently issued government agency-backed MBS, where balances on underlying mortgages are still relatively high. The model uses a scenario in which interest rates are relatively high and do not change, the equity market declines by 20%, demand for housing does not change, and unemployment increases by 2%. Based upon those inputs, the model indicates that prepayments will increase significantly over the next 6 to 18 months. Assuming the agency backing the MBS remains solvent, which of the following provides the most likely explanation for the increase in prepayments in the model scenario?
A
Curtailments are increasing.
B
Defaults are increasing.
C
More properties are being refinanced.
D
Turnover is decreasing.
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