Explanation:
B is correct. The economic conditions are conducive to increasing consumer defaults. For an agency mortgage, defaults are treated as prepayments since the principal payoff will be made whole by the backing agency.
A is incorrect. Curtailments (early partial repayment of principal amounts) typically occur when loans are relatively old and balances are low. This is not referenced in this scenario.
C is incorrect. Refinancing arises when a borrower prepays a mortgage in order to refinance the underlying property. The most likely reason for this is a decline in interest rates. If rates are high, there is less incentive to refinance.
D is incorrect. Turnover occurs when people sell their houses to move to a different location. Lower turnover results in fewer prepayments.
Learning Objective: Describe the mortgage prepayment option and factors that affect it; explain prepayment modeling and its four components: refinancing, turnover, defaults, and curtailments.
Reference: Global Association of Risk Professionals, Financial Markets and Products (New York, NY: Pearson, 2023). Chapter 18. Mortgages and Mortgage-Backed Securities
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Q-63. 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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