What Is the PSA Standard Prepayment Model?
The Public Securities Association Standard Prepayment Model (PSA) is the assumed monthly rate of prepayment that is annualized to the outstanding principal balance of a mortgage loan.
The Public Securities Association Standard Prepayment Model is one of several models used to calculate and manage prepayment risk specific to mortgage-backed securities (MBS) and collateralized mortgage obligations (CMO).
- The PSA standard prepayment model is used to estimate the prepayment risk associated with asset backed securities and mortgage backed securities.
- Prepayment risk is that loans packaged into a security will be paid off early due to refinancing or other reasons, affecting the securities duration and cash flows.
- The model, created by the Public Securities Association, assumes that prepayments on loans gradually rise to a maximum after 30 months.
The Public Securities Association Standard Prepayment Model (PSA) acknowledges that prepayment assumptions will change during the life of the obligation and may affect the yield of the security. The model assumes a gradual rise in prepayments, which peaks after 30 months. The standard model, called 100% PSA, starts with an annualized prepayment rate of 0% in month zero, with 0.2% increases each month until peaking at 6% after 30 months.
Prepayment assumptions are based on homebuyer data that shows that, during the first few years, a borrower is less likely to be willing or able to prepay the mortgage. This data makes sense, as a new homeowner is unlikely to move to a different home or immediately refinance, and the costs of buying a house generally don’t leave a lot of free cash flow for a new owner to make additional payments.
It is important to note that the PSA is just the most common prepayment model. There are different models, including proprietary ones, that can be used to model and evaluate prepayment in mortgage-backed investments. The Public Securities Association Standard Prepayment Model is also referred to as the PSA prepayment model.
The Importance of the Standard Prepayment Model to Investors
If the single monthly mortality (SMM) for a given MBS or CMO is above what was projected according to the PSA, then the security may see its overall lifespan shortened. This can result in capital being returned to the investors sooner than planned.
The return of capital through prepayment is generally a negative for investors, as prepayment tends to increase in low-interest environments, meaning the investors receive capital back that they must reinvest in a less favorable yield environment. So there is a negative impact on the trading value of a security that is exceeding the PSA. In the opposite case, the life of an MBS may be lengthened if the prepayment rates are below the PSA, assuming the PSA was used in the creation and marketing of the security.
Background on the PSA
The Public Securities Association Standard Prepayment Model was developed by the Public Securities Association in 1985. The Public Securities Association eventually became the Bond Market Association and, in 2006, it merged with the Securities Industry Association to become the Securities Industry and Financial Markets Association (SIFMA).
The prepayment model is still referred to by its original name, but due to the subsequent name changes of the association, it is sometimes called the Bond Market Association PSA. It is also quite common for the acronym for the model to be confused with the identical acronym for former Public Securities Association as well as an acronym for the function of the model, that is, providing a prepayment speed assumption (PSA).