What is ‘Dealer-Median Prepayment Speed’
Dealer-median prepayment speed is the median value of all the securities dealers’ prepayment speed estimates for the underlying mortgages used to form mortgage-backed securities.
In other words, the speed value is the speed at which the payment is made for underlying mortgages which to form the basis of mortgage-backed securities.
BREAKING DOWN ‘Dealer-Median Prepayment Speed’
The dealer-median prepayment speed is an important consideration, as it is the median measure of how fast mortgage borrowers will prepay their mortgages. Prepayment speed estimates are a crucial variable in the valuation and analysis of a mortgage-backed security. Investors and traders compete to develop more accurate proprietary models to outperform each other in the broader market.
Banks and other regulated financial enterprises use the prepayment speed estimate to value and manage mortgage-backed securities. This calculation raises a flag to regulators, due to its authenticity. The value can vary widely and is unregulated. Thus the dealer-median prepayment speed is used only to calculate more conservative estimates.
Why Dealer-Median Prepayment Speed Matters
The use of a prepayment model is to estimate the level of loan portfolio prepayment over a specific period. The model will take into consideration possible changes in interest rates. These estimates are based on mathematical equations and usually involve the analysis of historical prepayment trends. Prepayment models are then used to value mortgage pools such as Government National Mortgage Association (GNMA), or Ginnie Mae, securities or other securitized debt products.
A typical example, the Public Securities Association Standard Prepayment Model (PSA) by the Securities Industry and Financial Markets Association, is one method to calculate prepayment speed. The PSA model assumes increasing prepayment rates for the first 30 months and then constant prepayment rates thereafter. There are various other ways to figure prepayment speed.
Security dealers need to determine the risk involved in investing in a security. Since multiple methods can calculate that speed, dealers need a standardizing number with which to gauge the risk. They use the median of those various estimation methods, creating the dealer-median prepayment speed.
What Influences the Prepayment Rate?
Interest rates are the most significant factor to dealer-median prepayment speed. If interest rates rise, people do not want to exchange current mortgages for a higher interest rate note. Conversely, as rates fall, more people are likely to refinance to replace their current interest rate with a lower one. Increased refinancing of loans results in the existing pool mortgages being paid off before the anticipated maturity date. In a domino effect, prepayments reduce the ongoing mortgage payments, which reduce the stream of premium payments to the investors holding the mortgage-backed securities.