Media Effect in Mortgage Prepayment Model

 

In managing the cash flow risk of a residential mortgage portfolio, we need to measure and model the prepayment risk. Prepayment risk is the risk that borrower can prepay the loan early before the loan contractual maturity. For example, borrower may have a 30-year fixed rate loan by making the monthly payment for 360 months but may pay off the loan simply after two years due to job relocation. Such sudden payoff of the loan totally alters the cash follow structure of the mortgage and would have a significant impact on the pricing of the mortgage portfolio, the risk to which any mortgage modelers must pay close attention.

In addition to job relocation, one of the key reasons for prepayment is due to that fact that the market interest rate becomes lower than the contractual rate so that borrowers voluntarily prepay the loan and refinance to another loan with a lower interest rate. In general, not all the borrowers are rational, and they may not even pay attention to the low interest rate environment or even they pay attention to the news, they may be simply reluctant to refinance given the uncertain cost associated with the refinance.

There is an important driver in prepayment models which is called the “Media Effect”. The “Media Effect” tries to describe and capture how much borrowers have been influenced to make their prepayment decision when the “media” keeps talking about the low interest environment and the cost-savings if one refinances.

The “media effect” in prepayment modeling was introduced at least 20 years ago where the social medias were simply limited to the newspapers, radios, TV, etc.

Nowadays, the channels for social media becomes way beyond the newspapers, ratio, TV and information can be quickly disseminated through the ads in social media such as Facebook, LinkedIn, Instagram, etc., due to the rapid and extensive development in technology and internet.

Given such rapid change in social media communication, the mortgage modelers should really rethink how to incorporate and adjust the “Media Effect” component in the prepayment model.