Handbook of Asset and Liability Management: From models to optimal return strategies

13

Prepayments

Ami au prêter, ennemi au rendre.

13.1 THE ORIGINS OF THE PREPAYMENT PHENOMENON

13.1.1 Definitions

13.1.1.1 Prepayment

A customer linked to a bank with a mortgage contract has the opportunity to reimburse or to prepay the credit outstanding amount during the credit contractual life. This action modifies the credit schedule and is potentially costly for the ALM.

The prepayment may be total or partial (when the customer will prepay partially the outstanding amount).

The A/L manager will distinguish between two types of prepayments:

• Financial or rational prepayments: those prepayments are potentially cyclical.
• Statistical prepayments: those prepayments are partially irrational from an economic point of view.

13.1.1.2 Statistical or sociological prepayment

Statistically, there is always a minimum prepayment rate. This statistical prepayment rate is easily modelled or anticipated.

Financial market conditions will not explain those prepayments; the explanations are sociological:

• geographic mobility (work, home, etc.);
• decease/disability;
• customer financial situation change (inheritance, divorce, etc.).

They represent the minimal part of prepayments you cannot avoid, those prepayments are observed when the prepayment phenomenon has no economic interest: the statistical prepayment level does not depend on interest rate level. However, it may depend on the contract seniority or on other parameters not linked with the market.

For this reason, A/L managers call also ...