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MBS Valuation with Liquidation Rate A model of mortgage prepayment rates based on the neural net approach is proposed. The model for insured, closed, five-year term mortgages has been developed. The Standard Vector V is defined as increasing linearly for the first 42 months from 1.75% to 12% in 0.25% increments and then decreasing linearly from 12% to 6% in 0.33% decrements for the next 18 months. When the standard vector is used, the MBS PE attempts to compute an equivalent constant liquidation rate, i.e., a constant liquidation rate which produces the same price as the variable liquidation rate based on the above formula. In certain rare cases, however, an equivalent constant liquidation rate does not exist. The existing version of PE in those cases displayed equivalent constant liquidation rate and prepayment rate as zero. The proposed enhancement computes the constant liquidation rate for which the remaining principal balance at the month before the first maturing principal tranche is the same as remaining principal balance (RPB) using variable liquidation rate (Standard Vector). The MBS PE then also displays a warning message that a different constant equivalent liquidation rate was computed. The constant liquidation rate is computed by using Newton’s method to solve an equation for RPB as a function of the liquidation rate, keeping the other inputs constant. Since RPB decreases as the liquidation rate increases, RPB with zero liquidation rate is higher than RPB using standard vector, and RPB with 100% liquidation rate is lower than RPB using standard vector, the solution for the equation always exists, and the equivalent constant LQR rate can always be found.
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