Mortgage Prepayment Model, Sensitivity Analysis and Model Risk

Bill Burns, Ph.D. and Ying Shen, Ph.D.

Over the past few decades, prepayment modelers have been continuously updating their models to reflect a wide range of prepayment experiences. Frustratingly, few of these prepayment models have accurately predicted the market when a market crisis or other unforeseen event has occurred. Given the complex behavior of home borrowers who are affected by a large set of nonlinearly correlated economic and non-economic factors, it is not obvious that there is a perfect model that can adequately forecast prepayments for the next thirty years. Aided by decades of extensive research and a wealth of prepayment data on the impact of important underlying variables, the mortgage community has finally reached the conclusion that the quest for the perfect model is simply a delusion.