The PSA is a numerical scale that is used to measure the rate of principal prepayments on MBSs and to make assumptions on the future rate of prepayments. The PSA assumes that homeowners tend to make very little prepayments in the first several months of homeownership, make a steadily increasing amount of prepayments each month out to twoand- a-half years, and (beyond 2.5 years) prepayments continue at a constant rate over the remaining life of the pool. Specifically, the basic PSA model assumes of 0.2% annual prepayment in month 1, 0.4% annual prepayment in month 2, 0.6% prepayment in month 3, etc. The model increases prepayments by 0.2% (annualized) each month out to 30 months, and then levels out at an annualized rate of 6% prepayment per year thereafter. Logically, this prepayment pattern makes sense. A new homebuyer has typically just spent a thousand dollars inclosing costs and down payment to buy their house. This new homeowner usually wants to spend some additional dollars on home improvements or new furniture etc. However, after being in their home several years, they may have gotten a promotion, or need more space, or found out they didn’t really like the neighborhood. So, the basic PSA model takes these tendencies into account. The PSA prepayments are expressed as a percentage of this base model.
If a MBS has principal prepayments each month dollar and penny for penny at exactly the same rate as the model, the MBS is said to be prepaying at a rate of 100% PSA. If the prepayment cash-flow are twice the amount of the base model, then prepayments would be at 200%PSA; if they are 10 times as fast, 1000% PSA, if only half as much, 50% PSA etc. If the homeowners do not make any prepayments, the collateral is said to be paying at 0% PSA.
FORECASTING PREPAYMENTS
Obviously, the PSA and CPR can be used to analyze actual prepayment history on a specific pool, but more importantly, the PSA and CPR are used to analyze projected future cash-flows, average live, maturity, and yield to evaluate a specific pool prior to purchase. In order to do this, an assumption of future prepayment activity must be made.
Opposed to simply guessing about future prepayments, there are three tangible sources of information that can be used to help formulate a prepayment assumption (forecast): Review the actual prepayment history of the MBS; review the prepayments histories of other similar MBSs; review the prepayments histories of other similar MBSs; review the forecasts of the mortgage securities experts on Wall Street ( this is often referred to as the “street assumption” or “Bloomberg Median”). These sources of prepayment history and forecasts are reviewed and then the investor applies his/her feeling about the direction of interest rates and mortgage rates, and therefore, the possibility of the homeowners wanting to refinance their mortgages. Then, a reasonable and supportable prepayment assumption can be made.
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