A Model for Mortgage Termination and Performance

Jun Qin Wei Wang , Countrywide Security Corporation April 11, 2007

Abstract Prepayment, default, and delinquency are the three mortgage attritions faced by investors in mortgage world. The diculty of modeling the three mortgage attritions mainly lies in three aspects: 1) the dependence among these three risks is sequential (across time) and non-trivial; 2) estimation of temporally inhomogeneous prepayment baseline is complicated by noise with increasing volatility with time; 3)the unobserved heterogeneity in the three risks presents a challenge for accurate parameter estimation. We propose an innovative unied model for analyzing the three risks. This twostep mixture Multinomial Probit model can capture the sequential dependence among the three attritions. In addition, by using a Bayesian wavelet method, this model gives prepayment baseline estimates, which capture product-specic peaks with overall smooth backgrounds. Furthermore, by using Dirichlet mixture of normals to model the grands of the latent utilities, this model can discover heterogeneity in borrowers delinquency, prepayment and default behaviors after controlling loan-level characteristics. Our model is applied on industry data. Equipped with the two techniques, our model is found to be more consistent and reliable in parameter estimation and more accurate in prediction of events of loan termination and performance.

Corresponding author. Email: jun qin@countrywide.com Phone: 818-225-3934. We thank LoanPerfor-

mance, the founder and maintainer of the industrys largest mortgage securities and servicing database, for allowing us to use their data for this study. We also thank Anand K. Bhattacharya and Nancy De Liban for their support and comments. This paper is for research only and views are those of the authors and do not reect the viewpoint of CFC or CSC. All errors belong to the authors.

Keywords: mortgage termination and performance, competing risks, transition matrix models, multinomial probit, mixture model, mixture of Dirichlet Processes, Bayesian wavelet function estimation

Introduction

The mortgage and Mortgage-Backed Securities (MBS) markets have become a crucial part of US economy. In mortgage world, participants such as originators, servicers, companies, and investors face dierent attritions such as prepayment, delinquency, and default. Prepayment constitutes the major risk faced by lenders and investors in prime world and mortgage backed securities. However, the default and delinquency risks have gained more and more attention in recent years. A signicant portion of borrowers, for example 28.5 percent for rst quarter of 2005, go to subprime and ALT-A categories, which means $184 billion out of a total of $700 billion new originated loans in the rst quarter of 2005. Compared with the borrowers of prime loans, the borrowers of subprime and ALT-A sectors have lower credit scores and/or less complete documentations of income and/or asset level. The subprime loans and ALT-A loans are subject to more severe delinquency and default risks. To compensate for not only the prepayment risk but also the delinquency and default risks, the subprime and ALT-A lenders must charge higher price for higher risk spreads. Understanding of these risks is of crucial importance to the lenders, investors, and regulators because it is the basis for hedging, pricing and policy making in the huge mortgage and MBS markets. To study the relationships among these three risks, it is necessary to examine the three events. Prepayment: There are many ways to categorize prepayment. For instance, prepayment can be divided into two types: early payo and curtailment. Early payo is dened as the event of a loan being paid o before its maturity, while curtailment happens when the borrower(s) pays more than the scheduled payment without paying o the loan. Curtailment will not be discussed in this paper. The term prepayment used in this paper only refers to event of early payo. All early payos, resulting from moving, renance for better payment, or renancing for cash-out, are usually decisions up to the borrowers will. Delinquency: A loan is delinquent when the borrower(s) fails to make the scheduled 2

payment. In most cases, serious delinquency is a result of borrowers nancial problem. Delinquency is not a terminal state, nevertheless, it is a necessary intermediate state that leads to default. Default: In past research publications or reports, the term default has often been used loosely. Any of these events: delinquency, foreclosure, REO or loss, have been referred to as default. In this paper, default is dened as the event that either the borrower(s) loses title due to failure to pay his(their) mortgage, or when the lender charges o the loan. In either case, the loan is terminated. For default to happen, however, a loan has to go through a process that includes a few intermediate states including delinquency. This process is illustrated in gure 1. Compared with prepayment, default has its unique properties. First of all, prepayment and default are driven by dierent factors. Default is more likely to happen when borrowers encounter nancial diculties and cannot improve their nancial condition in a short time solo by their own eorts. Thus, default is necessarily preceded by delinquency. Moreover, default in most cases is not up to borrowers will; rather it is a combined result of borrowers behavior and servicing practice (see gure 1). Therefore, default is not an isolated probabilistic event. The three mortgage attritions, as mentioned in the above, have dierent causes but are not independent. To model one (or two) without the others will give a biased view of the whole picture. For the better business practice in mortgage market and in the trading of the MBS, it is desirable to model the three risks, simultaneously. In our paper, we propose a unied model that explains borrowers complicated behavior involving termination and performance. In mortgage world, two families of models are explored by researchers and business practitioners in analyzing these three risks: duration models and discrete choice models (DCMs). Since Green and Shoven (1986) rst used the proportional hazards model (PHM), a well known duration model introduced by Cox (1972), to analyze mortgage termination by renance, it has gained great popularity in this industry. However, most work focuses on modeling prepayment only. When the importance of studying relationships of dierent types of prepayment and default has become more apparent, there have been several attempts (HanHausman (1990), Deng, Quigley and Van Order (2000), Clapp, Deng and An (2006), etc.)

to generalize the PHM to address various mortgage terminations using the full maximum likelihood estimation. The natural alternative to the duration models in modeling mortgage termination events and performance is the DCMs. The DCMs have been established to be a powerful tool in modeling polychotomous choices. Unlike other time to event data (such as time to death/failure caused by diseases in medical study), mortgagees payments or termination decisions are observed regularly. In other words, borrowers make decisions of choosing among the options of fullling a payment, renancing, and skipping a payment every month. The DCMs require choice probabilities at every choice occasion to sum to one. Hence, an increase in the probability of a termination event must be oset by a decline in the sum of the remaining probabilities of the other termination events and the survival probability. With restructured event history data, Foster and Van Order (1985), Clapp et al. (2001) and Clapp, Deng, An (2006) have shown that a multinomial Logit model (MNL), introduced by McFadden (1974), is an attractive approach to modeling competing risks for default and prepayment. Despite the fact that duration models focus on modeling continuous time to event while DCMs focus on modeling discrete hazards with restructured event data, these two types of model share many similarities. Firstly, both models allow path dependence. The duration models assume that the hazard rates of the termination events at time t are conditioned on the subject survived up to time t-1. For the DCMs, researchers can build path dependency into the model structure as well by properly restructuring event data. Secondly, the PHM (a widely used duration model) and the MNL (a widely used DCMs) both assume proportional odds ratios among dierent alternatives at discrete time point1 . Although these two families of models share some similarities, there are some signicant dierences between these two. For instance, the DCMs can naturally capture delinquency states together with termination events, which duration models are not able to achieve without modication. The delinquency risk has a great impact on pricing in the primary and secondary markets, but it is the least studied mortgage risk among the three mortgage attritions. There are three major reasons that make it important to capture the delinquency
1

PHM assumes hi (t) = i (t)eXi , where i = {1, 2, , I} indices the ith type of event, and i is the
hi (t) hj (t)

baseline for the ith type of event. Therefore, at a very small time interval (t, t + t) during which at most one event happens, the odds ratio of the ith type of event against the j th type of event is =
i (t) X(i j ) j (t) e

states. 1) Delinquency incurs service cost such as collection fee, loss in interest, etc., increases losses for any institution guaranteeing timely payments, and impacts payments to subordinate tranches. Thus, the delinquency risk itself is of great interest to servicers, lenders, regulators, and investors. 2) Delinquency is the rst-and-must step leading to default-the longer and more severe a loan is in delinquency states, the more likely it will default. To better understand the default risk, it is helpful for researchers to understand the drivers of the delinquency risk. 3) The dependence of default on prepayment is through the dependence of delinquency on prepayment. This is a series of sequential decisions. Therefore, to understand the relationship between prepayment and default, researchers need to understand the relationships among delinquency, prepayment and default. Based on the above considerations, we conclude that the DCMs are more appropriate to serve our goal of capturing relationships among the prepayment, default, and delinquency risks, simultaneously. In this paper, we propose a DCM with interim loan states (current and delinquency 30 days, delinquency 60 days and above), prepayment, and default. One could choose to model more delinquency states. We include delinquency 60 days and above because 60 days late in payment is the trigger event of foreclosure procedure2 , and foreclosure is the rst legal step leading to default. Without surprise, we nd loans 60 days and above late in payment have dierent prepayment and default behavior from loans that are current or 30 days late in payment. The Multinomial Logit (MNL) model is one of the most frequently used models in the family of DCMs in analyzing polychotomous observations. Since Foster and Van Order (1985) rst built an option-based mortgage pricing model that estimates prepayment and default jointly using a Logit model, it has been widely used by GSEs, business practitioners, and researchers. The Logit (or MNL) model assumes that the latent dependent variables are composed by two parts, namely the deterministic part and the stochastic part. The deterministic part is a function of the covariates, while the stochastic part follows a Gumbel distribution (extreme value Type II distribution). By assuming the stochastic parts of all alternatives (options) to be I.I.D., the choice probabilities of the Logit model have the form of a logistic function. This makes the Logit model easy to estimate and interpret. However, the problem of assuming I.I.D. Gumbel distributions for the stochastic parts is that it leads to
2

Foreclosure procedure starts at 75 days late in payment.

the I.I.A. property3 . The I.I.A. is a very strong assumption and makes the multinomial Logit inappropriate for some categorical observations. Even though including dierent explanatory variables for default and prepayment is helpful for alleviating the severity of I.I.A. property, researchers and practitioners always face the chances of unable to include some variables of predictive power due to data availability at reasonable expenses. Hence, researchers usually need to perform I.I.A test for the MNL models. Instead of choosing a MNL, we use a Multinomial Probit model (MNP) in our paper. The advantage of the MNP over the MNL is that the MNP can allow a full rank variancecovariance matrix for the stochastic components of the latent dependent variables. Therefore, the MNP can help detect model misspecication and correlations among the unexplained prepayment, default, and delinquency risks. The MNP is motivated by the Central Limit Theorem. The Probit model assumes that the stochastic component is the sum of independent unobserved quantities. According to the Central Limit Theorem, the stochastic component in MNP follows a normal distribution instead of a double exponential distribution (Gumbel distribution). Unlike those of the MNL, the choice probabilities of the MNP no longer have a closed analytical form and cannot be easily estimated using the maximum likelihood method. With the advent of modern computation device and numerical integration techniques, Albert and Chib (1993) proposed a Gibbs sampler4 that made exact inference possible for the MNP. In section 4, we show that even with carefully chosen predictors there still exist correlations among the three mortgage attritions even after the inclusion of many important variables such as FICO, LTV (loan to value), HPI, unemployment rate, interest rate, etc. A well-recognized challenge in modeling prepayment behavior is that dierent products have dierent patterns of prepayment behavior given xed lender observed characteristics and macroeconomic variables. For instance, many studies have revealed that hybrid 2/28 loans have a prepayment peak at the end of the second year, which is due to borrowers aversion
3

Take the famous red bus and blue bus problem for an example. If only travel time matters for travelers

and without presence of blue bus, half of travelers choose train and the other half choose red bus. Fit a Logit model for this problem, and use it to predict how many people are going to choose train when there is blue bus available in addition to train and red bus. The prediction would be one third, which contradicts intuition. 4 Gibbs sampler is a special case of Metropolis-Hastings method (see Hasting (1973), Metropolis et al. (1953), Tanner and Wong (1987), Geman and Geman (1984), and Gelfand and Smith (1990)).

to the risk caused by interest uctuation and borrowers preference of xed mortgage rates. This product-specic temporally inhomogeneous prepayment behavior is captured in baseline hazards in the PHM and the MNL models. Yet, both of the baselines given by these two approaches show increasing volatility with time. This phenomenon is caused by the dramatic decrease in the number of observations when most loans experience prepayment opportunities and terminate as time passes. When most loans prepay, usually a larger percent of the remaining loans is subject to delinquency and default risks. Although default is a relative small risk compared with prepayment, it could cause bigger loss than prepayment. Quite naturally, it is of investors great interest to have accurate estimation of default probability at later life of loans, thus, accuracy in prepayment baseline estimation at later life of loans is not dispensable. In this paper, we propose to use the Bayesian wavelet method, a powerful and ecient tool in nonparametric regression, to model prepayment baseline. Wavelet methods can recover piecewise smooth functions with singularities at isolated points, which is desirable in our case. Moreover, wavelet coecients for piecewise smooth functions decay fast with the level of resolution. Compared with Fourier transformation methods, wavelet methods are more parsimonious in representing piecewise smooth functions. Furthermore, Bayesian wavelet methods can build prior knowledge about functions (smoothness and singularities) at dierent level and dierent shift. In our case, the Bayesian wavelet method gives us a de-noised baseline estimation, thus, avoids over-tting. Our study shows that with the Bayesian wavelet method, our model give more consistent and reliable parameter estimation, and provide more accurate projection for both the default probability and the prepayment probability. Another challenge of modeling the prepayment, default, and delinquency risks is how to handle unobserved heterogeneity besides lender observed heterogeneity of borrowers. For example, mortgagees are dierent in awareness of renance opportunities: some mortgagees are willing to spend a lot of time on collecting mortgage rates information in order to get a good deal, while others might be indierent to the uctuations of the mortgage rates. Ignoring the unobserved heterogeneity will lead to not only biased parameter estimations (Clapp, Deng, and An (2006)) but also biased baseline estimations. For example, suppose there is a pool of heterogeneous loans with two clusters of mortgagees, and one cluster of mortgagees is interest rate sensitive, while the other is not. At the beginning, the prepayment hazard 7

of this pool is a weighted average of the prepayment hazards of these two clusters. While mortgagees from the rate sensitive cluster exercise renance option at favorable environment as time passes by, the weight of the rate sensitive cluster decreases. Hence, the prepayment hazard of the pool decreases and gradually approaches the prepayment hazard of the rate insensitive cluster. In order to account for the unobserved heterogeneity in mortgage termination and performance, we need to build a model that, with enough data, is able to reveal clusters of dierent mortgagees in prepayment behavior given that all explanatory variables are xed. Put it in another way, if the intercept of the latent dependent variable (or utility) of prepayment can be viewed as the grand satisfaction brought by exercising prepayment option, the utilities of prepayment option should be normally distributed (for the MNP models) around intercept after the extraction of the total eect of all explanatory variables for a homogeneous pool of loans. Clapp, Quigley, and An (2006) proposed to adjust the unobserved prepayment heterogeneity by allowing borrowers randomly chosen from distribution with positive probability from xed mass points. This approach is motivated by the belief that there are a certain number of clusters (groups) of borrowers and borrowers act similarly within each group while signicantly dierently across groups. The authors show that their approach yields larger and more signicant coecients for several important variables, however, they admit that it is sometimes dicult to obtain convergence with their model. The challenge comes from determining the number of groups prior of model tting. Apparently, misspecication of the number of groups not only impedes model convergence but also introduces bias into parameter estimation. In our paper, we build a nite mixture model that uses a Dirichlet mixture of normals to estimate the underline distributions from which the utilities of prepayment, default, and delinquency are drawn. Dirichlet Processes (DPs) are known to be a powerful Bayesian nonparametric density estimation method in analyzing nite mixture models. The advantage of using a DP in our model is that it simultaneously estimates the number of groups and the distribution of each group. Moreover, it forms a conjugate family and thus makes inference easy. To summarize, the goals of our model are: to capture relationships among prepayment, default, and delinquency, simultaneously; 8

 to provide good baseline estimates for dierent products or group of loans in one model; to capture the unobserved heterogeneity in the mortgage termination and performance and discover potential model misspecication. The remainder of this paper is organized as follows. In section 2, we present the model and the empirical methods of modeling prepayment baseline and the unobserved heterogeneity. We describe the data in section 3 and the results in section 4. Finally, in section 5, we conclude the ndings of our study.

The Model

The discrete choice models are a well-known class of models for analyzing categorical data such as consumer brand choices. They are based upon the random utility maximization theory and assume that the decision makers always choose the options (among all available ones) that bring them the greatest satisfaction on every decision-making occasion. The extent of satisfaction is measured on a relative scale and is called utility. Since the extent of satisfaction is not observable (only the decisions are observed), the utility is called latent. In mortgage world, at every scheduled payment time, borrowers face a decision to make a payment, to make no payment, to exercise call option (to prepay), or to involuntarily exercise put option (to default). Since there are a limited number of actions that borrowers can take at every decision making time and dierent actions will bring them dierent nancial benets and consequences, the discrete choice models are appropriate for analyzing loan termination and performance. As subprime and ALT-A mortgage composites a signicant portion of mortgage backed securities, researchers have paid more and more attention to the default risk, as well as the relationship between the default and prepayment risks. The Logit, a member of the family of the DCMs, has gained great popularity in mortgage termination analysis, especially the prepayment analysis. Despite the fact that the MNL suers from the I.I.A. problem, in literature, very few attempts have been done in testing the I.I.A. assumption. There are two major reasons for this. First, the default risk is relative small compared to the prepayment

risk, especially for prime mortgage. In mortgage literature, most work focuses on prepayment only. Second, some researchers (MacDonald (2006)) argue that default is a very dierent process from prepayment and the correlation between the default and prepayment risks is not a big concern. Although default is not a pure probabilistic event and involves legitimate procedures, default and prepayment are by no means irrelevant. Prepayment can be roughly divided into two types, renance and sale. The motivations behind these two types of prepayment are dierent. Renance is mostly driven by the dierence between gain (market value of a loan minus the unpaid principal balance) and transaction cost incurred by renancing. Sale, on the other hand, is mostly driven by housing dissatisfaction, household mobility, and exogenous events such as divorce, retirement, and other change in family status. A sale occurs when a borrower moves out of the property and pays back the lender the unpaid balance. A default, on the other hand, occurs when a borrower moves out of the property without neither fullling payments as agreed upon by the borrower and the lender nor paying back the loan balance. Given that the borrower desires to move (due to housing dissatisfaction) or needs to move (due to unemployment, divorce, or nancial diculty), it is likely that the borrower will choose default if there is negative equity while choose sale if there is positive equity. However, evidences show that borrowers rarely default just because the put option is in the money. Archer, Ling and McGill (1996, 1997) established the concept that borrowers have three choices to terminate mortgages by move, renance or default, and listed several mobility variables aecting the move decision. However, their estimates combine the three choices together. Clapp et al (2001), Pavlov (2001), Goldberg and Harding (2003) and Deng, Pavlov and Yang (2005) showed that nancial considerations (such as value of the call option) are primary drivers of the optimal renance choice, while proxies for mobility characteristics of homeowners (e.g., age, income and minority indicators) are more important for the move decision. Considering MNL to be not sucient for mortgage termination analysis, An, Clapp, and Deng (2005) used a Nested Multinomial Logit model (NMNL) and nd signicant correlation between sale and default given some proxies for mobility characteristics of homeowners,. Although the NMNL model proposed by An, Clapp, and Deng (2005) partially avoids

10

the I.I.A. problem caused by correlation between sale and default, it ignores the fact that lenders cannot begin foreclosure petition until two payments are missed. In other words, the dependence between default and prepayment/sale is through the dependence between delinquency and prepayment/sale. Kau and Kim (1994), Ambrose, Buttimer, and Capone (1997), and Danis and Pennington-Cross (2005) pointed out that the borrowers decision on making no payments or delaying of foreclosure depends on their expectation on the property value in the future. For instance, if housing prices continue to drop in the future, the value of default will be larger in the future and the borrower might defer default and receive free rent at the same time. On the contrary, if house prices continue to increase, the value of prepayment will increase in the future and the borrower might delay foreclosure and sale the house in the future to minimize loss in property value. Realizing the importance of understanding delinquency behavior, Danis and PenningtonCross (2005) presented an NMNL model that models dierent delinquency states, default and prepayment together. In their model, they put prepayment and default in one group named terminate, dierent delinquency states such as 30 days, 60 days, and 90 days in another group named delinquent, and current as the third group. However, their model automatically assumes non-negative default probability at time t for loans that is current at t-1. This is because the NMNL does not assume that borrowers make decisions sequentially. Actually, the probability of an outcome of an NMNL model is specied as the product of the probability of being at a group and the probability of the outcome conditional on the chosen group. Therefore, the probability of the loans going from current at time t-1 to default at time t is P (current|t 1)P (terminate|t)P (default|terminate, t), which is a non-negative number. We notice that delinquency 60+ days is not only the rst-and-must step leading to default but also a good proxy for the need and (or) desire to move. Therefore, we separate prepayment into two types: pure prepayment (dened as a loan prepays when this loan is current or at most one month late in payment at previous month), and marked prepayment (dened as a loan prepays when this loan is at lest two month late in payment at previous month5 ). Apparently, default is conditionally independent from pure prepayment. In this
5

We choose two-month-late-in-payment as a trigger event, since foreclosure procedure starts as early as

a loan is 75 days late in payment. A borrower faces the decision to sale his house and pay back the loan balance or leave the house without payment after foreclosure procedure starts.

11

setup, we are able to model the dependence among marked prepayment, default, and delinquency 60+ days as well as the dependence between pure prepayment and delinquency 60+ days. In order to model delinquency, default, and prepayment simultaneously and sequentially, we propose a two-step Multinomial Probit model. The rst step is to model the transition vector from the state of current6 to the states of current, delinquent, and pure prepayment7 , and the second step is to model the transition vector from the state of delinquent to the states of current, delinquent, marked prepayment, and default. This two-step model allows a full rank variance-covariance matrix for stochastic components of the latent dependent variables. Thus, our model is capable of capturing not only relationships among dierent types of loan termination attritions (pure prepayment, marked prepayment and default), but also the relationship between loan performance and mortgage termination.

2.1

Structure of the model

There are four loan states in our model: 1) current and 30 days delinquent, 2) 60 days and above delinquent, 3) prepayment, and 4) default. Unless noted otherwise, we call the state of loans of being current and 30 days delinquent as the state of current and call the state of loans of being 60 days and above delinquent as the state of delinquent for the convenience of notation. We denote these four states as Cur, Dlq, Def, and P, respectively. Since utilities are relative measures8 , the latent utility for the state of current is set to zero for identication purposes. The latent utilities for default and delinquent contain three additive parts: xed utility, varying utility, and stochastic utility. Let i index loan, t
6

In our model, current is used to denote a state of loans of being current and 30 days delinquent. Similarly,

delinquent denotes a state of loans of being at least 60 days delinquent. 7 In our model, we separate prepayment into two types, marked prepayment and pure prepayment. For a loan that prepays at time t and is in the state of current at time t-1, we label this type of prepayment to be pure prepayment. On the other hand, for a loan that prepays at time t and is in the state of delinquent at time t-1, we label this type of prepayment to be marked prepayment. 8 If u1 , u2 , u3 are utilities for three options labeled as 1, 2, and 3, then u1 < u2 < u3 means that exercising option 3 brings the biggest satisfaction among the three and exercising option 1 brings the lowest satisfaction. Suppose C is any constant, then u1 +C < u2 +C < u3 +C gives the same ordering of satisfaction of exercising the three options. To solve this identication issue, one of the options is set to have constant zero utility.

12

index time, Rit denote the set of possible states that the ith loan could be at time t, and
Rit denote the realized state of the ith loan at time t. Therefore, if Ri(t1) = Cur, then Rit = {Cur, Dlq, P}; and if Ri(t1) = Dlq, then Rit = {Cur, Dlq, Def, P}. Let R = {Rit Rit , i = 1, , N ; T = 1, , Ti } denote the set of observations. If Ri(t1) = Cur, the rst

layer of the model is: Uit,Dlq|Cur = i,Dlq|Cur + it,Dlq|Cur +

it,Dlq|Cur it,P|Cur .

(2.1.1)

Uit,P|Cur = i,P|Cur + it,P|Cur + it +

On the other hand, if Ri(t1) = Dlq, the rst layer of the model is:

Uit,Dlq|Dlq = i,Dlq|Dlq + it,Dlq|Dlq + Uit,Def|Dlq = i,Def|Dlq + it,Def|Dlq + Uit,P|Dlq = i,P|Dlq + it,P|Dlq +

it,Dlq|Dlq it,Def|Dlq it,P|Dlq ,

(2.1.2)

where latent utility for state Cur is set to zero (Uit,Cur|Cur = 0 and Uit,Cur|Dlq = 0) and Uit,Dlq|Cur , Uit,Dlq|Dlq , Uit,Def|Dlq , Uit,P|Cur , and Uit,P|Dlq represent the latent utilities for the three loan states: delinquency, default and prepayment given previous loan states are current or delinquent, respectively. Similarly,i,| s, it,| s, and
it,| s

represent the xed

utilities, the varying utilities and the stochastic utilities of the corresponding loan states, respectively9 . it is the baseline prepayment utility. The baseline utilities are productspecic (or group-specic) functions. We handle borrowers sequential decisions by specifying i,| s, it,| s and
it,| s to be state dependent. If Ri(t1) = Cur, at time t bor-

rower i will realize one state from (Cur, Dlq, P) and this state has the maximum value
among (Uit,Cur|Cur , Uit,Dlq|Cur , Uit,P|Cur ). Similarly, if Ri(t1) = Dlq, at time t borrower i

will realize one state from (Cur, Dlq, Def, P) and this state has the maximum value among (Uit,Cur|Dlq , Uit,Dlq|Dlq , Uit,Def|Dlq , Uit,P|Dlq ). The stochastic utility is a random part of the latent utility that cannot be explained by the xed and varying (or time dependent) loan attributes and economic factors. matrix of { matrix of {
9

it,| s

are

independent across time and correlated among dierent loan states. Cur is the covariance
it,|Cur , i it,|Dlq , i

= 1, , N ; t = 1, , Ti ; Ri(t1) = Cur} and Dlq is the covariance = 1, , N ; t = 1, , Ti ; Ri(t1) = Dlq}. Cur and Dlq are two

| denotes {Dlq|Cur, P|Cur, Dlq|Dlq, Def|Dlq, P|Dlq}

13

symmetric positive denite matrices. For identication purposes, variances of

it,P|Dlq

it,P|Cur

and

of the covariance matrix Cur and Dlq are set to one10 .

The xed utilities are functions of loan and borrower attributes observed at loan origination and cannot be updated through time. For example, documentation type is a categorical variable and is used to categorize documentation and verication of income and asset. Naturally, we model loans with full documentation to have dierent utilities for the three mortgage attritions from those with reduced or alternative documentation. Another example is borrowers credit score, which is obtained in loan application and usually will not be updated. Similarly, the varying utilities are functions of time-varying loan attributes and microeconomic variables. For example, loan to value (LTV) is a variable calculated as loan amount divided by appraisal value of the property and recorded at loan origination. As time passes, the unpaid principal balance changes (usually decrease, except for negative amortization loans) and so does the value of the property. Therefore, LTV at time t can be calculated by dividing unpaid principal balance at time t by property value at time t(can be approximated by the original appraisal value times the number of times of Home Price Index (HPI) at time t relative to HPI at origination at MSA (or state) level.). Furthermore, the latent utility for prepayment option has one more additive component named baseline utility. Baseline prepayment utility is composed of product-specic/groupspecic functions. For example, xed rate loans and hybrid loans are dierent groups, loans with prepayment penalty and without prepayment penalty are dierent groups, etc. We are motivated by the observation that, even after controlling risk factors such as loan attributes and unemployment rate, there is still some non-stochastic movement in the prepayment behavior for dierent types (groups) of loans. For instance, for hybrid 30-year loans with xed rates in the rst two year and adjustable rates in the rest (2/28 loans), we see a renance peak around the end of the second year, which can be explained by the borrowers preference of xed mortgage rates to adjustable mortgage rates due to risk aversion. Another example is, for loans with prepayment penalty, we see a higher prepayment hazard after the
10

If u1 , u2 , u3 are utilities for three options labeled as 1, 2, and 3, divide u1 , u2 , and u3 by a positive

constant will not change the ordering of the three options. To solve this identication issue, in addition to xing one of the utilities to constant zero, it is conventionally assumed that utility of one of the remaining options has a constant variance.

14

prepayment penalty window than within the prepayment penalty window. These productspecic movements in prepayment hazards happen at particular times of loan life. Therefore, the second layer of the model is: i,| = Zi | + i,| it,| = Wit | + it,| it = Yi t + it where the xed utilities are regressed on the xed loan and borrower attributes Zi and the varying utilities are regressed on varying loan attributes and economic factors Wit . | denotes coecient vector for the xed loan attributes Zi for delinquency, default, and prepayment, respectively. | denotes the coecient vector for the time-varying predictors11 . By specifying coecient vectors to depend on the previous loan states, we allow borrowers at dierent states to react dierently to market information. The baseline prepayment utility it is a function of Yi -a vector of dummies denoting dierent groups of loans. t is a vector and each element of it is the baseline prepayment utility for loans of the corresponding group at time t. We assume that i,| s, it,| s and it s are independent across loans and across dierent states. We use V| to denote the variance of i,| (i = 1, , N ). In order to capture the unobserved heterogeneity in the delinquency, default and prepayment behaviors, we use Vi,Dlq , Vi,P , and Vi,Def to denote variances of i,Dlq|Cur , i,P|Cur , and i,Def|Dlq , respectively for the ith loan. We will provide more detail about the empirical method we use to handle the heterogeneity in what follows. Furthermore, we use V,Dlq|Cur , V,Dlq|Dlq , V,Def|Dlq ,V,P|Cur , V,P|Dlq and V to denote the variances of it,Dlq|Cur , it,Dlq|Dlq , it,Def|Dlq , it,P|Cur , it,P|Dlq , and it (i = 1, , N ; t = 1, , Ti ). For identication purposes, we assume V,Dlq|Cur , V,Dlq|Dlq , V,Def|Dlq , V,P|Cur , V,P|Dlq and V to be a single xed positive number which is relatively small compared with the variances of
11

(2.1.3)

it,P|Cur

and

it,P|Dlq

12

Both | and | depend on the previous loan states, where | denotes Rit |Ri(t1)

{Dlq|Cur|, P|Cur, Dlq|Dlq, Def|Dlq, P|Dlq}. 12 We assume that V,Dlq|Cur , V,Dlq|Dlq , V,Def|Dlq , V,P|Cur , V,P|Dlq and V are equal to 0.0001.

15

2.2

An Empirical Method of Modeling Prepayment Baseline

It is noticed that at dierent stages of its life, a loan shows a time dependent prepayment potential given that the economic environment, the lender observed borrower characteristics, and the loan attributes are xed. The change in prepayment hazards is product-specic. Conventionally, there are two ways to obtain the prepayment baseline hazards. Researchers (Green and Shoven (1986), Han-Hausman (1990), Deng, Quigley and Van Order (2000), Clapp, Deng and An (2006)) have used proportional hazards model to analyze the prepayment behavior and capture product-specic temporal inhomogeneity non-parametrically. Clapp, Deng, An (2006) t a multinomial Logit on mortgage panel data. In their paper, the authors derive baseline hazards in prepayment probability by allowing a time varying intercept. The baseline hazards of these two approaches show increasing volatility with loan age. This increasing volatility is caused by a decrease in the number of loans. As the loans in a pool evolve with time, most of them experience renance opportunities and terminate. As the result, the number of observations decreases dramatically, which makes the coecient and baseline estimation less reliable. Since the remaining loans are subject to greater default risk and therefore more likely to bring greater loss to investors, the accuracy in estimating mortgage termination hazards at later part of loan life is not dispensable. In general, good estimates of baseline function should pick product-specic peaks at a few specic time points while remain reasonably smooth at the rest on time span. We nd the Bayesian wavelet methods appealing for the purpose of prepayment baseline estimation. Firstly, wavelet methods are powerful tools in nonparametric regression and handle temporal (or spatial) inhomogeneous function very eciently. As Donoho et al. (1995) point out that the advantages of the method are particularly evident when the underlying function has jump discontinuities on a smooth background. Because the supports of wavelets can be arbitrarily small and be any part of the real line, wavelet methods can capture any local abrupt changes. Secondly, wavelet method is computationally attractive. Wavelet bases are usually orthonormal and they transform white noises into white noises. Through Discrete Wavelet Transformation (DWT), an observed function f (f = + e), which is composed of a target function (usually dened on a nite interval) and a white noise e of variance 2 , can be transformed into f (f = + e), composed of wavelet coecients and white 16

noise e of variance 2 . Thus, the problem of function estimation is translated into the
s one of estimating of the wavelet coecients. Thirdly, for functions in Besov space Bp,q (M ),

such as piecewise smooth functions with local singularities, the wavelet coecients decay very fast. This results in a parsimonious representation of the original function in wavelet coecient spaces. Lastly, the Bayesian wavelet decompositions can model prior information about smoothness at dierent levels of detail and at dierent shifts. So, the baseline prepayment utility for a particular group j, jt , is regressed on some wavelet basis . The third layer of the model: j = j + j . (2.2.1)

Where j = (j1 , j2 , , jT ) , j = (j1 , j2 , , jT ) , and j = (j1 , j2 , , jT ) is a vector of the wavelet coecients for group j. T usually takes a value of 2h (h is an integer). Since for major products (such as xed rate loans, hybrid 2/28 loans and 3/27 loans) the prepayment hazards atten out after ve years since the loan origination, in our analysis, it is reasonable for us to consider T = 64(h = 6). To use wavelet methods to estimate functions on nite intervals, one must pay attention to the articial discontinuities at the origin and the end. Usually, one adapts to a nite interval by simply periodizing the function, thus, introducing undesired oscillation around boundaries. In our case, the baseline prepayment hazard at the origin is away from that after ve years. Neither do we want smoothing of these two hazards nor do we want oscillation around the origin and the end. The most commonly used approaches of handling boundary issue are periodic, symmetric and antisymmetric method (Daubechies (1992), Jawerth and Sweldens (1994), and Ogden (1997)). In this study, we reect baseline prepayment hazards around the end point (T = 64) and mandatorily makes the extended baseline prepayment hazards symmetric around T = 64. With this articially introduced symmetric property, we avoid the boundary issue and adopt the Bayesian wavelet method for the baseline hazards function estimation on T = 128(h = 7) data points for each group of loans. Usually, choosing the optimal wavelet basis is non-trivial. It depends on the characteristics of the target function for estimation. In our case, since researchers and practitioners noticed that many product-specic prepayment peaks happen at the end of loan years (e.g. month 12, 24, 36, etc.), it is reasonable for us to choose Daubechies wavelet basis of order 6, the wavelets of the nest resolution of which have non-zero values on 12 consecutive points 17

and vanish out on the rest of the support. Donoho and Johnstone (1995) proposed several threshold wavelet estimators and showed that these estimators are near-minimax simultaneously over a whole interval of a Besov scale. These estimates are widely used in engineering elds such as image processing for denoising. Recently, Chipman et al. (1997), Abramovich et al. (1998), Clyde and Gorge (1998), Vidakovic (1998), and Muller and Vidakovic (1999) presented various Bayesian thresholding and shrinkage approaches and showed that Bayesian wavelet threshold estimators are less ad hoc. Muller and Vidakovic (1999) in their paper presented a prior probability model in the wavelet coecient space which automatically thresholds the wavelet coecients by full posterior inference. In our model, we adopt this approach for our prepayment baseline estimation. After a small modication, the baseline prepayment utility for a group j, j , can be written as, j = (Sj j ) + j , (2.2.2)

where (Sj j ) is the component-wise product (sj1 j1 , sj2 j2 , , sjT jT ), and Sj = (sj1 , sj2 , , sjT ) is a vector of dummies indicating whether jt s are killed or kept. For the convenience of notation, we use double indices (k, m). jt is denoted as j(k,m) , where t = 2k + m, k 0, , log2 (2T ) 1, and m 1, , 2k. We specify the prior distribution of j(k,m) to be a mixture of two normal distributions,
2 j(k,m) |sj(k,m) sj(k,m) N(0, j 2ck ) + (1 sj(k,m) )N(j(k,m) , j(k,m) )

(2.2.3)

where sj(k,m) follows a Bernoulli distribution sj(k,m) Bernoulli(ck ), j s and j s are posj
2 itive scalars, and j(k,m) and j(k,m) are empirical mean and variance of j(k,m) . Although 2 the choice of j(k,m) and j(k,m) does not change asymptotic distribution, it does alter the

simulated Markov chain and thus is critical for an ecient implementation. Here, we use the empirical mean and variance of j(k,m) obtained in the burn-in stage. As k increases, j(k,m) decays for a function in a Besov space. Typically, a shrinkage wavelet estimator shrinks the coecients of high frequency (resolution) more heavily. This motivates researchers to set shrinking priors on wavelet coecients. We set the hyperparameter c to be one. The above setting allows us place more emphasis on j(k,m) of lower level (resolution). 18

The hyperparameter j follows an inverse gamma distribution, j IG(a , b ) and the hyperparameter j follows a Beta distribution, j Beta(a , b ). The full conditional distribution for sj(k,m) is a Bernoulli distribution with log odds ratio
2 log(p/(1 p)) = ck log(j ) log(1 ck ) j(k,m) (j(k,m) 2(k,m) j )/(2j ) (2.2.4) j 2 2 log(2j 2ck )/2 j(k,m) /(2j 2ck ) + log(2j(k,m) )/2 2 +(j(k,m) j(k,m) )2 /(2j(k,m) ), 2 where j is the variance of j . Note that (k, m) is the tth (t = 2k + m) row of wavelet basis

. Given sj(k,m) , the full conditional distribution for j(k,m) is [j(k,m) |sj(k,m) , rest] sj(k,m) N(j(k,m) , where
2 j(k,m) 2 j(k,m) ) 2 + (1 sj(k,m) )N (j(k,m) , j(k,m) ), (2.2.5) 2 2 j(k,m) /j .

2 2 = j j 2ck /(j + j 2ck ), and j(k,m) = ((k,m) j )

The full conditional distribution for j has no close form, but can be simulated using Metropolis-Hastings method. For a random walk proposal density13 , the acceptance ratio is min 1, (new )a (1 new )b j j (old )a (1 old )b j j
(k,m) (k,m)

((new )ck )sj(k,m) (1 (new )ck )1sj(k,m) j j ((old )ck )sj(k,m) (1 (old )ck )1sj(k,m) j j

(2.2.6)

The full conditional distribution for j is an inverse gamma distribution j IG(aj, , bj, ) where aj, = a + #{sj(k,m) = 1} and bj, = b +
(k,m){(k,m):sj(k,m) =1} 2 2ck j(k,m) .

(2.2.7)

In our study, we set a = 4, b = 2, a = 1, and b = 10. We use a Gibbs sampler to draw j(k,m) s, sj(k,m) s, j s, and j s from their full conditional distributions in turn, and make full posterior inference based on the Gibbs sampler14 . In section 4, we will show the estimation results and how the wavelet transformation method de-noises and smoothes out the uctuations in prepayment baseline in our model.
13

A random walk proposal density is any density which satises: P (x |x) = P (x|x ). In this paper, we use

x = arctan(tan(x /2) + ) + 1/2, where is a random normal ( N(0, 0.1)). 14 For detailed explanation, please refer to Muller and Vidakovic (1999).

19

2.3

An Empirical Method of Accounting Unobserved Heterogeneity in Mortgage Termination and Performance

In general, there are four types of factors that inuence borrowers prepayment and default decisions: loan characteristics, borrower characteristics, housing market conditions, and nancial market conditions (Clapp, et al. 2006). As noted in the literature, economic variables such as unemployment rate, HPI, and interest rate are well-known proxies for job loss and renance opportunities. In addition to these economic variables, payment history is another proxy of borrower motivation for moving. In addition, some other most commonly used predictors for prepayment and default are the loan characteristics recorded at (after) origination such as loan amount, coupon rate, loan type, second loan to value, etc. and the borrower characteristics such as income, obligation ratio (DTI), etc. Among these four types of factors, some are hard to obtain for legal reasons and (or) nancial reasons. For instance, to avoid mortgage lending discrimination15 in business practices, the originators are required to disclose their business practice in the communities they serve based on the Home Mortgage Disclosure Act16 . However, when the originators securitize their loans, they do not report certain borrowers information such as age, gender, religion, ethnic, race, etc. Although this borrower information has potential predictive power in explaining prepayment and default heterogeneity, it is not available for researchers in analyzing mortgage termination and performance behavior. As noted in the above, the delinquency, prepayment and default behaviors are potentially subject to unobserved borrower heterogeneity. Ignoring unobserved heterogeneity leads to biased (toward zero) parameter estimations. Therefore, a statistical method that accounts for unobserved heterogeneity may improve a models predictive power for mortgage termination. To solve
15

Mortgage lending discrimination is the practice of banks, governments or other lending institutions

denying loans to to one or more groups of people primarily on the basis of race, ethnic origin, sex or religion. One of the most notable instances of wide-spread mortgage discrimination occurred in United States inner city neighborhoods from the 1930s up until the late 1970s. 16 The Home Mortgage Disclosure Act (HMDA) was enacted by Congress in 1975 and is implemented by the Federal Reserve Boards Regulation C. This regulation provides the public loan data that can be used to assist: 1) in determining whether nancial institutions are serving the housing needs of their communities; 2) public ocials in distributing public-sector investments so as to attract private investment to areas where it is needed; 3) and in identifying possible discriminatory lending patterns.

20

the subject level heterogeneity, researchers have proposed several approaches such as latent class, hierarchical Bayes, nite mixture of normals, Dirichlet mixture of normals (Allenby and Lenk (1994,1995), Lenk, DeSarbo, et al (1996), Allenby, Arora and Ginter (1998), Kim (2003)) in the marketing literature. In the mortgage literature, Deng, Quigley, and Van Order (2000) and Clapp, Deng, and An (2006) addressed this issue by assuming borrowers coming from a nite number of distinct groups in the PHM and the MNL framework, respectively. Using this method to account unobserved heterogeneity in prepayment, the authors show that their model yields larger and more signicant coecients for several important variables. However, assuming xed mass point distribution for unobserved heterogeneity rules out the possibility of capturing variation within the same class. This approach is sensitive to specication of the number of groups and subject to the potential of introducing bias into parameter estimation. Here, we use the Dirichlet mixture of normals to address the borrower heterogeneity. Dirichlet Process (DP) is a Bayesian nonparametric density estimation method introduced by Ferguson (1973, 1974). It is widely used in nonparametric estimation in statistical applications after Escobar (1994, 1995) developed and extended a Gibbs sampler that makes Bayesian inference for density estimation pragmatic. The approach of Dirichlet mixture of normals circumvents the need of determining the number of mixing components and estimates the number of mixing components as a by-product of the MCMC procedure. The second layer of our model is modied as the following i,Dlq|Cur = Zi(1) Dlq|Cur,(1) + i,Dlq|Cur i,P|Cur = Zi(1) P|Cur,(1) + i,P|Cur i,Def|Dlq = Zi(1) Def|Dlq,(1) + i,Def|Dlq , where Zi(1) is obtained by excluding constant from Zi = (1, Zi(1) ) , and i,Dlq|Cur , i,P|Cur and i,Def|Dlq are assumed to be independent across i = 1, , N and follow the normal distributions N(i,Dlq|Cur |i,Dlq , Vi,Dlq ), N(i,P|Cur |i,P , Vi,P ) and N(i,Def|Dlq |i,Def , Vi,Def ), respectively. Suppose that i,P = (i,P , Vi,P )(i = 1, , N ) come from some prior distribution G() on R R+ and are modeled as a Dirichlet Process with precision parameter and baseline density G0 () dened on R R+ . Then i,P s come from a Dirichlet mixture of normals (Escobar (1994,1995), Ferguson (1983), West (1990)). The precision parameter is a positive 21 (2.3.1)

scalar and represents how concentrated G() is around G0 (), so that E(G()) = G0 (). We specify G0 () to take a form which is conjugate to the normal/inverse Gamma model (Escobar
1 (1995)). Thus, under G0 (), we assume Vi,P Gamma(q/2, Q/2), where q and Q are the

shape and scale parameters, respectively, and i,P N(m, factor > 0.

Vi,P ) for some mean m and scale

Given P = {i,P , i = 1, , N } and Dirichlet Process D,P dened on G0 () with precision parameter , the conditional distribution P (N +1,P |P , G0 (), ) is
N

P (N +1,P |P , G0 (), ) = (G0 (N +1,P ) +

j=1

j,P (N +1,P ))/( + N )

where j,P (N +1,P ) denotes point mass at j,P . Thus, the predictive distribution for the (N + 1)th observations is P (N +1,P |P , G0 (), ) = (P (N +1,P |N +1,P )dP (N +1,P |P , G0 (), ))
N

= (Tq (m, M ) +
j=1

N(i,P , Vi,P ))/( + N ),

where Tq (m, M ) is a students t distribution with q degree of freedom, location parameter m, and scale parameter M = (1 + )Q/q.

As showed in Escobar (1995), the full conditional distribution for i,P (i = 1, , N ) given P = {j,P ; j = 1, , i 1, i + 1, , N }, G0 (), and P = {i,P , j = 1, , N } is [i,P |P , G0 (), P ] [i,P |P , G0 (), P ][i,P |i,P ] [i,P |P , G0 ()][i,P |i,P ] (G0 (i,P ) +
j=1, ,N ;j=i (i) (i) (i) (i) (i)

j,P i,P )N(i,P |i,P ) qj j,P (i,P ),

j=i

q0 Gi (i,P ) +

where Gi (i,P ) is the posterior distribution of i,P given observation i,P and prior G0 (). And q0 ((1 + )Q)1/2 ((q + 1)/2)/(q/2)(1 + (i,P m)2 /((1 + )Q))(q+1)/2 and qj exp{(i,P j,P )2 /(2Vj,P )}(2Vj,P )1/2 . Actually, q0 is proportional to the precision parameter times a students t distribution Tq (m, (1 + )Q) evaluated at i,P and qj is proportional to a normal distribution N(j,P , Vj,P ) evaluated at i,P . 22

Due to the clustering of the elements of P = {i,P , i = 1, , N }, the number of dis tinct values of P will reduce to much fewer than N . We use P = {i,P = ( , Vi,P ), i = i,P

1, , N } to denote the set of distinct values of P , and usually the number of distinct values N is much smaller than N ). With the conditionally conjugate structure, we can include the learning about the prior parameter m and and ( from data by assuming m N(a, A)
1 1 j (Vj,P ) ) /(A +

IG(w/2, W/2). The full conditional distribution of m is independent from the

1 1 j (Vj,P ) ) )

Dirichlet Process and is a normal distribution with variance AN = A ( and mean aN = AN (a/A +
j

/( Vj,P )). The full conditional distrij,P 2 j (j,P m) /Vj,P .

bution of is IG(wN /2, WN /2), where wN = w + N , WN = W +

To learn

from the data about the precision parameter , we assume Gamma(a , b ). The full conditional distribution of is proportional to Gamma(a , b )N (+N ) (x (1x)N 1 dx)17 . In the above, we described the full conditionals for the parameters of the Dirichlet mixture of normals for modeling unobserved heterogeneity of the prepayment behavior18 . We adopt the same method for modeling the unobserved heterogeneity of the default and delinquency behaviors. We use the hyperparameters a = 0, A = 10000, w = 4.2, W = 2, and a = b = 0.01N .

2.4

Computation

To estimate the whole model, we use a Gibbs sampler with which we draw parameters , , , , and hyperparameters iteratively from their full conditional distributions: Step I: Given observations of loans performance and termination status, i,| , it,| , it , covariance matrix Cur and Dlq , simulate Uit,| for i = 1, , N and t = 1, , Ti . Step II: Given Uit,| , | , | , and , update i,| , it,| , it for i = 1, , N and t = 1, , Ti . Step III: Given Uit,| , i,| , it,| , it , update Cur and Dlq .
17

This distribution has no close form.

With an augmentation variable such that P (, |n )

Gamma(a , b )N ( + N ) (1 )N 1 , the full conditional of is a mixture of two Gamma distribution. For detail illustration, please refer to Escobar (1995). 18 For more detail of Gibbs sampler for Dirichlet mixture of normals, please refer to Escobar (1995).

23

 Step IV: Given i,| , it,| , it , and variances of i,| , it,| , it , draw | , | , and from their full conditional distributions. Step V: Draw the prepayment baseline wavelet coecient vector j and Sj for group j = 1, , J as previously illustrated in this section. Step VI: Simulate the distribution for the delinquency grand, the prepayment grand and the default grand as previously illustrated in this section. Step VII: Repeat step I to VI until MCMC converge.

Data

We study industry subprime loans originated from 1998 to June of 2006 obtained from LoanPerformance (LP, formerly MIC). From all originators, we select a particular one that the subprime loans originated by whom in each year are a signicant portion of the industry production in subprime sector of that year, and the important loan information such as LTV, loan amount, FICO, etc. are complete and clean19 . For this originator, we get totally 533812 number of loans after the initial data screen and cleaning for the time window of 1998 to June of 2006. We randomly sample 5.5% from the pool and t our model on this portion of the data set (in-sample data)20 . We use the remaining portion of the data set (out-of-sample data) for validation purpose. In table I, we list the averages of important loan characteristics for the in-sample data by vintage and in total, and in table II, we list the averages of important loan characteristics for the out-ofsample data by vintage and in total. From these four tables, we show that our in-sample data set is a good representation of the target population for this originator in the time window.
19 20

We select this particular originator for research purpose only. Since MCMC method is computationally intensive and the total number of observations is quite big for

a desktop with a 2.40GHz C.P.U., we sample 5.5% of total population as the in-sample data to t our models and reserve the rest for validation purpose. Although 5.5% is a relative small portion of the population, however, the results of our study show that validation of the out-of-sample data using model estimates obtained from the in-sample data is reasonably good.

24

3.1

Variables Used for Analyzing Mortgage Termination and Performance

Researchers (Hendershott and Van Order (1987) and Kau and Keenan (1995)) have shown that the right to prepay the mortgage provides the borrower a call option on the mortgage debt and that the choice to default the mortgage provides the borrower a put option on the collateral. The strike prices of the call option and the put option are both equal to the unpaid mortgage balance. However, borrowers do not exercise the call and put options as rational as expected by researchers (Green and LaCour-Little (1999), Deng, Quigley and Van Order (2000)). This is because the prepayment and default behavior incur several kinds of cost, such as, transaction costs, residence cost, and cost of maintaining qualied credit, information seeking, etc., which makes prepayment and default cannot be fully explained by option theory alone. This suggests that researchers need to select predictors with caution when analyze mortgage termination. To capture transactions costs, it is natural to use the dierence between the borrowers note rate and the market rates since the higher mortgage rate relative to the current market rate, the higher current market value of this loan relative to the loan balance. Clapp, Deng, and An (2006) suggested including unpaid loan balance in the models of renancing, because the larger the loan balance, the greater the dollar amount of benets from renancing. They argued that under xed transactions costs (e.g., the time costs of renancing), the larger the loan amount, the more nancial benet gained from renancing, thus, resulting in bigger probability of renance. Archer, Ling, and McGill (1996) found that after controlling for call option values, LTV ratios and DTI are negatively related to prepayments. Bennett, et al. (2001) also found that high current LTV signicantly reduces the probability of renancing. This agrees upon the economic theory in transaction cost, since given a xed value in property, the higher the loan amount, the lower the chance for the borrower to nd a renance oer. Caplin, Freeman, and Tracy (1997), Mattey and Wallace (2001) and Downing, and Stanton and Wallace (2001) found that the dynamics in regional property markets and Housing Price Index (HPI) had signicant impact on the mortgage prepayment performances. This is easy to imagine because the local HPI uctuation and regional property market trends aect LTV ratio through aecting property values in communities. Without surprise, Pavlov (2001) found that slope of the yield curve has a positive eect on prepayment 25

because it captures overall economic conditions. Deng, Quigley and Van Order (1996) found that unemployment and divorce had predictive power in explaining prepayment behavior. In addition, Bennett, et al. (2001) found that poor credit history signicantly reduced the probability of renancing. As discussed by Clapp, Deng, and An (2006) if collateral value declines below the loan balance, additional cash will be required to renance. Similarly, a borrower whose income or nancial position deteriorates may be unable to renance due to payment-to-income or credit quality constraints. Based on the results mentioned in the above, we use current LTV, loan amount, FICO, unemployment rate (at MSA level), lag of slope, low FICO indicator, low loan amount indicator, a variable stands for short term HPI change (annualized average HPI change in past three months), and a variable stands for median term HPI change (annualized average HPI change in past six months)21 . To capture the incentive for borrowers to renance from current loans adjustable rate loans, we use an incentive variable (we call it incentive type 1) dened as the maximum of the dierence between note rate at time t and two interest rates - LIB6M and MTA - at t-1. To capture the incentive for borrowers to renance from current loans to xed loans, we use another incentive variable (incentive type 2) dened as the dierence between note rate at time t and Freddie rate at time t-1. It is believed that borrowers utilities for the call option increase slowly at the low incentive and high incentive scenarios, therefore, we use an incentive variable (labeled as incentive S curve) dened as arctangent of the dierence between the note rate at time t and Freddie rate at time t-1. As discussed earlier, we try to put dierent product types in one model. To estimate the baseline for these product types, we include dummies indicating seven loan groups: xed, hybrid 2/28, hybrid 3/27, loans with prepay penalty term for 12 months, loans with prepay penalty term for 24 months, loans with prepay penalty term for 36 months, and loans with prepay penalty term for 60 months. Turning to the marked prepayment and default, more and more researchers have noticed that many borrowers do not default although their houses have substantial negative equity. Apparently, these two attritions are driven by borrowers nancial diculty and exogenous events that seriously deteriorate borrowers nancial ability such as job loss as found by Vandell (1995) and Archer, Ling and McGill (1997), Deng, Quigley and Van Order (1996,
21

We do not use DTI since it is not available for the loans of the Originator we choose in LoanPerformance

database.

26

2000), Pavlov (2001), and Deng, Pavlov and Yang (2005). Ambrose, Buttimer, and Capone (1997) argued that longer delays (more expected delinquency) in foreclosure and higher LTV were associated with higher default probabilities. Based on the result mentioned, we use current LTV, unemployment rate (MSA level), 0.1Dt , 0.01D2 and Dt t
1/2

as predictors for

marked prepayment and default, where Dt denotes months staying in the state of delinquency. Turning to delinquency, researchers (Ambrose and Capone (2000)) found that labor market and housing market are good proxies for borrowers nancial condition. It is also found that borrowers credit score, LTV at origination, income, and nancial asset are signicant predictors for delinquency ratios (See, Morton (1975) and Furstenberg (1974), Chinloy (1995), Getter (2003), Calem and Wachter (1999)). Besides current LTV and unemployment rate (at MSA level) used as predictors for delinquency, we notice that delinquency ratios increase during the rst two years and then decrease and atten out after three to four year. Therefore, suppose DAge denotes number of months since origination, we use DAge , DAge , 0.01D2 , 0.001D3 as additional predictors for delinquency. Age Age In addition to the above variables, we use some loan characteristics such as occupancy type, property type, documentation type, purpose, risk grade type, state, etc. at origination for the prepayment, delinquency, and default analysis. We also include several other variables: a variable standing for Credit Curing (CC: an dummy indicating if a loan is in the state of current for the past 12 months), a variable standing for Average Credit Curing (ACC: ratio of the number of delinquent months to the total months since origination), an indicator for spring (March, April, and May), an indicator for summer (June, July, and August), and an indicator for fall (September, October, and November). Furthermore, making the right renancing decision requires ongoing monitoring of market conditions and ready access to lenders. Deng and Gabriel (2004) argued that dierent demographic groups (e.g., minorities versus white) had dierent access to information or lenders. For default decisions, we conceive that dierent demographic groups have dierent spending and saving habits and dierent levels of eort of maintaining credit scores. Borrower level demographic data are not always available at reasonable expenses. Therefore, we add three distribution free random eects for prepayment, default and delinquency, which allow data to reveal potential clusters of borrowers with dierent prepayment, default and delinquency behaviors.
1/2

27

Finally, we include several interaction terms of the predictors to explain the potential prepayment, default, and delinquency behaviors: an interaction between purpose and incentive type 1, an interaction between purpose and incentive type 2, an interaction between loan amount and incentive 1, an interaction between loan amount and incentive type 2, an interaction between FICO and incentive type 1, an interaction between FICO and incentive type 2, an interaction between FICO and ACC and incentive type 1, an interaction between FICO and ACC and incentive type 2.

Result

To check the model structure and the two empirical methods, we tted two models: the two-step MNP model and the two-step MNP model with baseline de-noising using Bayesian wavelet method and accounting heterogeneity in the prepayment and the default risks using Dirichlet mixture of normals. For convenience of reference, we call the latter one the extended model. Table III22 and table IV present the posterior means and posterior standard deviations (in parenthesis)23 of coecients of xed utilities for the two models given that loans are in the state of current or the state of delinquent at time t-1, respectively. Similarly, table V and table VI show the posterior means and posterior standard deviations (in parenthesis) of coecients of varying utilities for the two models given loans are in the state of current or the state of delinquent at time t-1, respectively. Table III, IV, V, and VI show that parameter estimates for most explanatory variables given by these two models have the same signs. For instance, compared with Owner Occu22

Although the information included in tabels I-XI has been obtained from sources that Countrywide

Securities Corporation (CSC) believes to be reliable, we do not guarantee its accuracy or completeness. CSC does not make any guarantee on returns of the investments and past performance is not indicative of future returns. The materials contained herein are being provided for illustration purposes only and CSC makes no representation as to their accuracy or completeness. Assumptions underlying any computation or valuation materials are subject to change without notice. CSC may have acted as an underwriter, have a position, makes a market, purchase or sell the same on a principal basis or as agent in the securities discussed. Nothing herein is or shall be construed as an oer to buy or sell securities. CSC is a member of NASD/SIPC. 23 *** means a coecient is signicant at 0.1% level, ** means a coecient is signicant at 1% level, and * means a coecient is signicant at 5% level.

28

pied (OO), borrowers for Second Home (SEC) and Investment (INV) are less likely to prepay at time t given that the loan is current at time t-1. Compared with OO, borrowers for SEC and INV are more likely to prepay at time t given that the loan is delinquent at time t-1 after controlling the other factors. Compared with OO, borrowers for SEC are less likely to become delinquent at time t given the loan is current at time t-1 after controlling the other factors. On the other hand, compared with OO, borrower for INV are more likely to become delinquent at time t given the loan is current at time t-1 after controlling the other factors. Compared with OO, borrowers for INV are more likely to stay in delinquent or go to default at time t given the loan is delinquent at time t-1 after controlling the other factors. For both of these two models at time t, after controlling the other factors and given the loans are current at time t-1, loans with low documentation are more likely to become delinquent compared with loans with full documentation, loans originated because of renance (for cash-out purpose or non-cash-out purpose) are less likely to become delinquent compared with loans originated because of purchase, loans with higher risk grades such as A- and B are more likely to become delinquent compared with loans of lower risk grade D or missing risk grade, loans originated in California are less likely to become delinquent compared with loans originated in the other states, and loans are less likely to become delinquent as FICO increases. For the two-step MNP model at time t, after controlling the other factors and given that the loans are current at time t-1, xed (coupon rate) loans are less likely to become delinquent compared with hybrid loans, additionally, if given that FICO is greater than 550, loans are more likely to become delinquent as loan amount at origination increases and the slope of the increments increases as FICO increases, whereas, if given that FICO is smaller than 550, loans are less likely to become delinquent as loan amount at origination increases and the slope of the increments increases as FICO increases. However, for the extended model at time t, after controlling the other factors and given that the loans are current at time t-1, xed loans are more likely to become delinquent compared with hybrid loans, additionally, if given that FICO is smaller than 650, loans are more likely to become delinquent as loan amount at origination increases and the slope of the increments decreases as FICO increases. For both of these two models at time t, after controlling the other factors and given the loans are current at time t-1, loans with low documentation are less likely to prepay 29

compared with loans with full documentation, loans originated because of renance for cashout purpose are more likely to prepay compared with loans originated because of purchase, loans with high risk grade A- are more likely to prepay compared with loans of risk grade of D or missing, loans originated in California are more likely to prepay compared with loans originated in the other states, loans are more likely to prepay when FICO increases, and loans are more likely to prepay when loan amount at origination increases and the slope decreases as FICO increases. Similarly, for both of these two models at time t, after controlling the other factors and given the loans are delinquent at time t-1, loans with low documentation is less likely to stay delinquent compared with loans with full documentation, loans originated because of renance for cash-out purpose are less likely to stay delinquent compared with loans originated because of purchase, loans with risk grade B are less likely to stay delinquent compared with loans of risk grade D or with missing risk grade, and loans originated in California are less likely to stay delinquent compared with loans originated in the other states. For the two-step MNP model at time t, after controlling the other factors and given the loans are delinquent at time t-1, loans are more likely to stay delinquent when FICO increases and loans are less likely to stay delinquent as loan amount at origination increases. For these two models at time t, after controlling the other factors and given the loans are delinquent at time t-1, loans originated because of renance (for cash-out purpose or non-cash-out purpose) are less likely to default compared with loans originated because of purchase, loans with high risk grade such as A- and B are less likely to default compared with loans of low risk grade such as D or with missing risk grade. For the two-step MNP model at time t, after controlling all the other factors, loans originated in California are less likely to default compared with loans originated in the other states, and loans are more likely to default when FICO increases. For both of these two models at time t, after controlling the other factors and given the loans are delinquent at time t-1, loans with property type Single Family Residential (SFR) are less likely to prepay compared with the loans of the other property type, loans with low documentation is more likely to prepay compared with loans with full documentation, loans originated because of renance (for cash-out purpose or non-cash-out purpose) are more likely to prepay compared with loans originated because of purchase, loans with risk grade

30

B and C are more likely to prepay compared with loans of risk grade D or with missing risk grade, and loans with risk grade A- are less likely to prepay compared with loans of low risk grade D or with missing risk grade. For the extended model at time t, after controlling the other factors and given the loans are delinquent at time t-1, loans are more likely to prepay as loan amount at origination increases, and loans are more likely to prepay as FICO increases but the slope of the increments decreases as loan amount at origination increases. For these two models, we nd that at time t after controlling the other factors and given loans are current at time t-1, current LTV has negative impacts on the delinquency and prepayment risks, type 2 incentive has negative impacts on the delinquency and prepayment risks, and type 3 incentive has a negative impact on the delinquency risk and a positive impact on the prepayment risk. Similarly, lag of slope has a negative impact on the prepayment risk and a positive impact on the delinquency risks, credit curing and average credit curing have positive impacts on the prepayment risk and negative impacts on the delinquency risk, spring and summer indicator have negative impacts on the delinquency risk and positive impacts on the prepayment risk, short term average HPA has positive impacts on the delinquency and prepayment risks, and medium term average HPA has a negative impact on the delinquency risk and a positive impact on the prepayment risk. For the extended model, we also nd that, after controlling other factors and given loans are current at time t-1, type 1 incentive has a positive impact on the delinquency risk, unemployment rate has a positive impact on the delinquency risk and negative impact on the prepayment risk, and the delinquency risk for xed loans has a dierent function of time from that of the hybrid loans. Similarly, for these two models, we nd that at time t after controlling the other factors and given loans are delinquent at time t-1, current LTV has negative impacts on the delinquency, default, and prepayment risks, type 2 incentive has positive impacts on the delinquency, default, and prepayment risks, type 1 and 3 incentives have negative impacts on the delinquency, default, and prepayment risks, unemployment rate has a negative impact on the default risk, lag of slope has positive impacts on the three risks, spring and summer indicator have negative impacts on the three risks, and medium term average HPA has negative impacts on the delinquency risk and the prepayment risk. For the extended model, we also nd that after controlling other factors and given loans are delinquent at time t-1, short term average HPA has a negative impact on the default risk. 31

Tables VII and table VIII present the posterior means and posterior standard deviations of variance-covariance matrices for the two models given that loans are in the states of current or delinquent at time t-1, respectively. The results of these two models show that the correlation between delinquent and default and the correlation between delinquent and prepayment are negative and signicant given that loans are delinquent at time t-1. The posterior distributions for the grand of the prepayment risk and the grand of the default risk given by Dirichlet mixture of normals do not reveal apparent clusters of populations. However, the top plot and the middle plot in gure 2 show that the posterior distributions for the grands of the prepayment risk and default risk are both right skewed24 , which means that some borrowers are more likely to prepay and/or default than the rest even after controlling all the explanatory variables. We nd that the grand of the delinquency risk has multiple components as shown in the bottom plot of gure 2. These three gures state that the extended model is more appropriate since data reveal unobserved heterogeneity in the mortgage termination and performance after controlling lender observed borrower heterogeneity. Figures 3 and 4 compare baseline estimates for dierent products and dierent group of loans given by the two-step MNP model and the extended model25 . In order to disentangle prepayment baseline eects and prepayment heterogeneity, we restrict the baseline of the xed loans to have an average of zero across time for the extended model. Therefore, the baselines for the xed loans, hybrid 2/28 and hybrid 3/27 loans given by the extended model are around zero. The baselines for the above three products given by the two-step MNP model have averages around the mean value of the prepayment grand given by the extended model26 . From gures 3 and 4, we see that the baselines of the extended model have peaks at several crucial points (e.g. month 24 for the loans with 24-month prepay penalty window) while remain overall smooth. By using Bayesian wavelet method, the extended model can distinguish noises in prepayment behavior from underline prepayment trends, thus, avoid
24

The skewness of the distributions of the prepayment grand and the default grand are 0.08439645 and

0.00503727, respectively. 25 The solid lines represent the posterior means of the baselines of the extended model and the dashed line represent the posterior mean of baselines of the two-step MNP model. 26 The estimated distribution of prepayment grand given by the extended model has a mean value of -2.845.

32

over-tting caused by random noises, which the two-step MNP model faces. For illustration, we include gures 5, 6, 7, and 827 , the top right plots of which show actual monthly prepayment ratios28 versus predicted monthly prepayment ratios29 given by the extended model and the two-step MNP model for in sample data and out of sample data, respectively. From these plots we conclude that the predicted monthly prepayment probability given by the twostep MNP model has uctuation after 24 months for in sample data and out of sample data due to the over-tting of the baselines estimation. On the contrary, the predicted monthly prepayment probability given by the extended model has a rather smooth background. In the mean while, it captures prepayment peak at month 24 and month 36 due to rate change for hybrid loans and(or) prepay penalties. Another advantage of Bayesian wavelet method in baseline estimation is the parsimoniousness of representation. If we set the threshold to keep or kill a wavelet coecient to be that the posterior mean of the corresponding indicator is greater than 0.1 and the posterior mean of the wavelet coecient is signicant at 5% level, there are 23 wavelet coecients kept for the baseline for loans with xed coupon rates. Similarly, there are 29, 18, 23, 34, 41, and 1 wavelet coecients to be kept for the baselines for hybrid 2/28 loans, hybrid 3/27 loans, loans with a one-year prepayment penalty term, loans with a two-year prepayment penalty term, loans with a three-year prepayment penalty term, and loans with a ve-year prepayment penalty term. Apparently, the Bayesian wavelet method gives more parsimonious representations of prepayment baselines. In addition to the above ndings, we now show how these two models perform in projection of the other two mortgage attrition risks. The top left plots of gures 5, 6, 7, and 8 show actual monthly delinquency ratios30 versus predicted monthly delinquency ratios31 and
27

The actual survival rate and predicted survival rate are plotted in every gure. Actual survival rates

at time t are calculated as St = St1 (1 (Nt,Def + Nt,P )/Nt ) and predicted survival rate is calculated as St = St1 i (Pi(t1),Cur + Pi(t1),Dlq Pit,Cur Pit,P ), where Nt is the number of loans at risk and uncensored at time t, Nt,Def and Nt,P are the numbers of loans default and prepay during the period t, and Pit,Def , Pit,P , Pit,Cur , Pit,Dlq are the estimated marginal probability of default, prepayment, current, and delinquent for the ith loan during the period t(given that the ith loan is uncensored during the period t). 28 Actual monthly prepayment ratio at time t is calculated as Nt,P /Nt . 29 Predicted monthly prepayment ratio at time t is calculated as i Pit,P /(Pi(t1),Cur + Pi(t1),Dlq ). 30 Actual monthly delinquency ratio at time t is calculated as Nt,Dlq /Nt . 31 Predicted monthly delinquency ratio at time t is calculated as i Pit,Dlq /(Pi(t1),Cur + Pi(t1),Dlq ).

33

the bottom left plots of these gures show actual cumulative default probabilities32 versus predicted cumulative default probabilities33 given by the two models for both the in-sample data and the out-of-sample data. These plots show that the extended model gives not only more accurate projection of monthly prepayment ratio but also more accurate projection of monthly delinquency ratio and cumulative default probability. Although the accuracy of the projection of the three risks can be reected from the dierence between the actual risk and the predicted risk (such as the dierence between the actual survival curves and the predicted survival curves, the dierence between actual monthly prepayment ratio and the predicted prepayment ratio, the dierence between actual monthly delinquency ratio and the predicted monthly delinquency ratio, and the dierence between the actual cumulative default probability and the predicted cumulative default probability), we would like to have a quantied measure to tell which model is better. To quantify and measure the accuracy of the estimated probabilities for the three risks, we calculate relative entropy between observations of terminal events and delinquency events and estimated probabilities of these events for these two models. The relative entropy (or Kullback-Leibler divergence, or information divergence, or information gain) is Ti calculated as: N log2 ((Pit,Cur + Pit,Dlq + Pit,Def + Pit,P )Pit,R ), where Pit,Cur , Pit,Dlq ,
i=1 t=1
it

Pit,Def , and Pit,P are the estimated probabilities for the ith loan at time t for states in Cur, Dlq, Def, P, respectively. The two-step MNP model gives relative entropy of 868863.239 for in-sample data and of 18502559.151 for out-of-sample data. The extended model gives relative entropy of 738926.579 for in-sample data and of 14712128.004 for out-of-sample data. Since the smaller the relative entropy is, the more likely the data is generated by the estimated distribution, the extended model better describes both in-sample and out-of sample data than the two-step MNP model does.

Conclusion

In this paper, we propose an innovative unied model for the competing mortgage termination and delinquency risks using a two-step mixture Multinomial Probit model. We test
Actual cumulative default probability at time t is calculated as 33 Predicted cumulative default probability at time t is calculated as Pi(t 1),Dlq )), where S0 = 1.
32 t t =1 St 1 (Nt ,Def /Nt ), where S0 = 1. t t =1 St 1 ( i Pit ,Def /(Pi(t 1),Cur +

34

our model on public industry data: subprime loans originated from 1998 to June of 2006 of a particular originator. Using these data, we illustrate that our model can capture the sequential dependence among the prepayment, default, and delinquency risks. Results show that with careful selection of explanatory variables, the unexplained behavior in the pure prepayment risk and the unexplained behavior in delinquency risk are uncorrelated. However, our model nds that the unexplained parts of the marked prepayment risk and the default risk are negatively correlated with that of the delinquency risk. Using Bayesian wavelet method, our model gives product-specic baseline prepayment hazards, which can distinguish prepayment trends from noise, thus avoid over-tting in baseline estimation. Using Dirichlet Process to model the distributions of the grands of the latent utilities for delinquency, prepayment and default, our mixture model discovers right skewness in both the grand of the prepayment risk and the grand of the default risk and the existence of multiple components in the grand of the delinquency risk after controlling lender observed loan-level characteristics and economic variables. Equipped with de-noised baseline estimation and accounted heterogeneity, our extended model provides more consistent and reliable parameter estimates than the two-step MNP model. Furthermore, using relative entropy as a measure of the distance between observations and the underline distribution of the data, our extended model gives smaller relative entropy for both the in-sample and the out-of-sample data than the two-step MNP model, which proves that our extended model gives more accurate estimation of mortgage termination events and delinquency event. The research in this paper shows very promising results in more properly modeling the complicated relationships of delinquency, default and prepayment. However, the model we propose requires intensive computation in both model estimation and prediction. Moreover, we have only included one delinquency state in this paper. To better understand the evolution of delinquency events such as 30 days late in payment, 60 days late in payment, 90 days late in payment, etc., one needs to make modication on model structure accordingly. Of course, the more states to include, the more computation intensity it demands.

35

Appendix
Joint Distribution and Full Conditionals
The joint distribution of all parameters of interest is: [, , , S|Data]
N Ti Uit,R|R
i(t1)

<Uit,R |R
it

i(t1) {[Uit,R|Ri(t1) |i,R|Ri(t1) , it,R|Ri(t1) , it , Ri(t1) ]

{
i=1 t=1

{
RRit

[it,R|Ri(t1) |Zit , R|Ri(t1) , VR|Ri(t1) ]}[it |, , S, V ]} [i,R|Ri(t1) |Zi , R|Ri(t1) , V,R|Ri(t1) ]}[][][][S],

RRit

where [], [], [], [S] are prior distributions of corresponding parameters. Suppose that the prior distribution for vectors of coecients Dlq|Cur , Dlq|Dlq , Def|Dlq , P|Cur , and P|Dlq for xed utilities is a multivariate normal distribution MVN(0, V ), where 0 is a vector of zeros and V is a positive denite diagonal matrix. Therefore, the full conditional distribution of Dlq|Dlq , and P|Dlq is [| |Rest]
N N

exp(| (
i=1 N

Zi Zi /V| + Zi Zi /V| +

V1 )| /2
N

+ |
i=1

Zi i,| /V| )
N

MVN((
i=1

V1 )1 (
i=1

Zi i,| /V| ), (
i=1

Zi Zi /V| + V1 )1 ).

Since we model the distribution of xed prepayment utility to be a Dirichlet mixture of normals, the full conditional distributions of P|Cur,1 and Dlq|Cur,1 are slightly dierent from that of Dlq|Cur : [P|Cur,1 |Rest]
N N

exp(P|Cur,1 (
i=1 N

Zi,1 Zi,1 /Vi,P +

V1 )P|Cur,1 /2
N

+ P|Cur,1
i=1 N

Zi,1 (i,P|Cur i,P )/Vi,P ) Zi,1 Zi,1 /Vi,P + V1 )1 ),

MVN((
i=1

Zi,1 Zi,1 /Vi,P +

V1 )1 (
i=1

Zi,1 i,P|Cur /Vi,P ), (

i=1

36

[Dlq|Cur,1 |Rest]
N

exp(Dlq|Cur,1 (
i=1 N

Zi,1 Zi,1 /Vi,Dlq + V1 )Dlq|Cur,1 /2 + Dlq|Cur,1

Zi,1 (i,Dlq|Cur i,Dlq )/Vi,Dlq )

i=1 N N N

MVN((
i=1

Zi,1 Zi,1 /Vi,Dlq + V1 )1 (

i=1

Zi,1 i,Dlq|Cur /Vi,Dlq ), (

i=1

Zi,1 Zi,1 /Vi,Dlq + V1 )1 ).

Similarly, the full conditional distribution of Def|Dlq,1 is [Def|Dlq,1 |Rest]

N

exp(Def|Dlq,1 (
i=1 N

Zi,1 Zi,1 /Vi,Def + V1 )Def|Dlq,1 /2 + Def|Dlq,1

Zi,1 (i,Def|Dlq i,Def )/Vi,Def )

i=1 N N N

MVN((
i=1

Zi,1 Zi,1 /Vi,Def +

V1 )1 (
i=1

Zi,1 i,Def|Dlq /Vi,Def ), (

i=1

Zi,1 Zi,1 /Vi,Def + V1 )1 ).

Suppose that for variable utilities the prior distribution for the vectors of coecients Dlq|Cur , Dlq|Dlq , Def|Dlq , P|Cur , and P|Dlq is a multivariate normal distribution MVN(0, V ), where V is a positive denite diagonal matrix. Therefore, the full conditional distributions of |Cur s (|Cur denotes Dlq|Cur, P|Cur) are [|Cur |Rest]
N,Ti N,Ti

exp(|Cur (
i=1,t=1 N,Ti

Zit Zit /V,|Cur + Zit Zit /V,|Cur +

V1 )|Cur /2

+ |Cur
i=1,t=1

Zit it,|Cur /V,|Cur ) + V1 )1 ).

MVN((
i=1,t=1

N,Ti N,Ti 1 1 V ) ( Zit i,|Cur /V,|Cur ), ( Zit Zit /V,|Cur i=1,t=1 i=1,t=1

Similarly, the full conditional distributions of |Dlq s (|Dlq denotes Dlq|Dlq, Def|Dlq, and P|Dlq) are [|Dlq |Rest]
N,Ti N,Ti

exp(|Dlq (
i=1,t=1 N,Ti

Zit Zit /V,|Dlq + V1 )|Dlq /2 + |Dlq

i=1,t=1 N,Ti

Zit it,|Dlq /V,|Dlq ) + V1 )1 ).

MVN((
i=1,t=1

Zit Zit /V,|Dlq +

N,Ti 1 1 V ) ( Zit i,|Dlq /V,|Dlq ), ( Zit Zit /V,|Dlq i=1,t=1 i=1,t=1

37

Suppose the prior distribution for vectors of coecients t (t = 1, , T /2) for the prepayment baseline utilities are a multivariate normal distribution MVN(0, V ), where V is a positive denite diagonal matrix. Therefore, the full conditional distributions of t s (t = 1, , T /2 1) are [t |Rest]
N N

exp(t (
i=1,Ti t N

Yt Yt /V + Yt Yt /V +

1 V )t /2

+ t
i=1,Ti t

Yt it /V )
1 + V )1 ).

MVN((
i=1,Ti t

N 1 1 V ) ( Yt it /V ), ( Yt Yt /V i=1,Ti t i=1,Ti t

Since we assume that the prepayment baseline for any group j attens out after t = T /2. Thus, the full conditional distribution of T /2 is [T /2 |Rest]
N,Ti N,Ti

exp(T /2 (
i=1,t=T /2 N,Ti

Yt Yt /V +

1 V )T /2 /2 N,Ti

+ T /2
i=1,t=T /2

Yt it /V )
1 + V )1 ).

MVN((
i=1,t=T /2

Yt Yt /V +

N,Ti 1 1 V ) ( Yt it /V ), ( Yt Yt /V i=1,t=T /2 i=1,t=T /2

38

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44

Table I Loan Characteristics for an Originators Subprime Loans Originated In 1999-2006 (In Sample Data)
Year Number of Obs. Avg LTV Avg. Appraisal Value Avg. Orig NoteRate Avg. Reset Freq. Avg FICO Avg LoanAmt Amortization Term 15Years 30Years SFH Property Other OWN SEC Occupancy INV PUR CashOut Purpose Documentation Type NoCashOut Full Low AB C D MIC Grade NA Other State CA Fixed Product Type ARM No Prepay Penalty Yes NoPnlty 1Y 2Y 3Y Prepay Penalty Term 4Y 5Y NonHybrid 2Y 3Y Hybrid Term Other 1998 1687 79.8 1.79E+05 9.9 4.1 597 99626 5.80% 94.10% 91.40% 8.50% 94.50% 0.80% 4.60% 46.40% 39.90% 13.50% 83.00% 16.90% 75.50% 17.80% 6.00% 0.50% . 92.10% 7.80% 38.90% 61.00% 39.80% 60.10% 39.90% 12.40% 21.40% 22.30% 0.30% 3.40% 38.90% 43.60% 6.20% 11.00% 1999 2449 79.7 1.87E+05 10 3.6 588 101713 3.70% 96.20% 88.20% 11.70% 94.40% 0.50% 5.00% 45.20% 43.00% 11.60% 84.40% 15.50% 70.00% 21.90% 7.60% 0.30% . 86.20% 13.70% 40.20% 59.70% 29.20% 70.70% 29.20% 6.80% 19.30% 35.50% 0.30% 8.70% 40.20% 39.00% 19.00% 1.60% 2000 2662 79.9 1.88E+05 10.6 4.1 585 101972 3.30% 96.60% 90.40% 9.50% 94.30% 0.30% 5.20% 46.40% 45.00% 8.50% 85.90% 14.00% 66.00% 26.30% 7.60% . . 86.10% 13.80% 32.10% 67.80% 23.50% 76.40% 23.50% 4.70% 20.60% 38.70% 0.20% 12.00% 32.10% 44.70% 22.90% . 2001 3461 80.9 1.98E+05 9.7 3.7 602 111423 2.80% 97.10% 89.90% 10.00% 91.20% 0.70% 8.00% 35.50% 57.20% 7.10% 80.80% 19.10% 80.60% 14.10% 5.20% . . 85.70% 14.20% 37.80% 62.10% 22.90% 77.00% 22.90% 6.30% 19.50% 41.20% 0.00% 9.90% 37.80% 42.60% 19.30% 0.10% 2002 5056 81.3 2.02E+05 8.6 4.8 609 117150 2.20% 97.70% 91.70% 8.20% 90.80% 0.30% 8.70% 30.90% 61.00% 8.00% 79.30% 20.60% 77.30% 8.30% 4.30% . 10.00% 87.80% 12.10% 19.20% 80.70% 18.50% 81.40% 18.50% 5.60% 27.00% 41.20% 0.00% 7.40% 19.20% 49.40% 31.10% . 2003 5459 80.8 2.26E+05 7.5 4.2 618 136154 2.70% 97.20% 89.80% 10.10% 92.10% 0.40% 7.40% 29.70% 63.80% 6.40% 80.30% 19.60% 88.60% 7.40% 3.80% . . 79.40% 20.50% 30.40% 69.50% 20.90% 79.00% 20.90% 5.90% 37.40% 32.90% 0.10% 2.40% 30.40% 53.40% 16.00% . 2004 3608 81.2 2.31E+05 7.1 4.8 615 141926 1.90% 98.00% 89.10% 10.80% 93.90% 1.00% 5.00% 27.80% 67.00% 5.10% 78.80% 21.10% 85.60% 7.30% 4.30% . 2.60% 85.00% 14.90% 20.60% 79.30% 28.20% 71.70% 28.20% 6.90% 42.10% 22.30% . 0.20% 20.60% 64.70% 14.40% . 2005 3918 81.9 2.63E+05 7.4 5 614 157605 1.00% 98.90% 86.60% 13.30% 92.60% 1.50% 5.70% 32.60% 58.30% 8.90% 69.30% 30.60% 55.10% 5.70% 4.90% . 34.10% 91.90% 8.00% 17.40% 82.50% 32.30% 67.60% 32.30% 7.40% 43.70% 15.40% . 0.90% 17.40% 74.00% 8.40% 0.10% 2006 1265 80.7 2.78E+05 8.1 5.2 612 164850 0.80% 99.10% 88.30% 11.60% 94.70% 2.00% 3.20% 39.10% 55.90% 4.80% 65.00% 34.90% 54.70% 5.00% 5.10% . 35.00% 91.60% 8.30% 14.10% 85.80% 33.40% 66.50% 33.40% 6.50% 45.80% 14.10% . . 14.10% 75.70% 9.50% 0.50% Total 29565 80.9 2.21E+05 8.4 4.4 608 126769 2.40% 97.50% 89.40% 10.50% 92.70% 0.80% 6.40% 34.20% 58.00% 7.70% 78.10% 21.80% 74.70% 10.60% 5.00% 0.00% 9.50% 86.40% 13.50% 26.20% 73.70% 25.90% 74.00% 25.90% 6.60% 32.90% 29.80% 0.10% 4.40% 26.20% 55.80% 17.10% 0.60%

45

Table II Loan Characteristics for an Originators Subprime Loans Originated In 1999-2006 (Out Of Sample)
Year Number of Obs. Avg LTV Avg. Appraisal Value Avg. Orig NoteRate Avg. Reset Freq. Avg FICO Avg LoanAmt Amortization Term 15Years 30Years Other Property SFH OWN SEC Occupancy INV PUR CashOut Purpose Documentation Type NoCashOut Full Low AB C D MIC Grade NA Other State CA Fixed Product Type ARM Other No Prepay Penalty Yes NoPnlty 1Y Prepay Penalty Term 2Y 3Y 4Y 5Y NonHybrid 2Y Hybrid Term 3Y Other 5.80% 10.20% 17.60% 1.30% 21.80% 0.10% 18.20% . 28.80% . 15.60% . 14.10% . 9.30% 0.10% 8.60% 0.40% 16.00% 0.50% 58.50% 41.50% 10.30% 18.60% 24.60% 0.20% 4.40% 44.90% 38.80% 72.60% 27.30% 6.30% 17.70% 39.70% 0.20% 8.40% 46.40% 34.40% 77.40% 22.50% 5.60% 19.10% 40.00% 0.30% 12.20% 37.20% 40.70% 79.50% 20.40% 6.30% 18.40% 43.30% 0.20% 11.10% 43.30% 38.30% 81.40% 18.50% 5.60% 27.30% 40.40% 0.00% 7.80% 21.30% 49.60% 78.90% 21.00% 5.70% 36.30% 33.80% 0.10% 2.90% 31.60% 52.70% 70.40% 29.50% 7.20% 41.00% 21.80% 0.00% 0.20% 20.40% 65.40% 70.10% 29.80% 8.20% 47.00% 13.90% 0.00% 0.80% 13.20% 77.10% 69.10% 30.80% 7.80% 49.60% 11.50% . 0.00% 11.50% 79.30% 74.30% 25.60% 6.80% 33.70% 29.00% 0.10% 4.50% 26.70% 56.50% 1998 30002 79.4 1.80E+05 9.9 3.7 599 98377 16.10% 83.80% 8.20% 91.70% 94.80% 0.50% 4.60% 43.40% 43.30% 13.10% 84.50% 15.40% 72.20% 19.70% 7.40% 0.50% . 91.00% 8.90% 35.00% 54.70% 10.10% 41.40% 1999 43773 79.6 1.82E+05 10.1 3.3 587 98127 13.20% 86.70% 10.10% 89.80% 94.00% 0.50% 5.30% 44.70% 43.30% 11.80% 83.80% 16.10% 67.90% 23.70% 8.00% 0.20% . 88.50% 11.40% 37.00% 53.50% 9.40% 27.30% 2000 47635 79.7 1.85E+05 10.7 3.8 584 99843 10.40% 89.50% 10.00% 89.90% 93.80% 0.50% 5.50% 44.10% 46.50% 9.30% 85.20% 14.70% 65.20% 26.60% 8.00% . 0.00% 87.70% 12.20% 30.00% 62.70% 7.20% 22.50% 2001 57351 81 1.92E+05 9.8 3.4 601 108166 10.30% 89.60% 9.10% 90.80% 91.20% 0.60% 8.00% 35.40% 57.00% 7.50% 82.20% 17.70% 80.00% 14.40% 5.30% . 0.00% 87.10% 12.80% 35.80% 56.60% 7.40% 20.40% 2002 81999 81.4 1.99E+05 8.7 4.7 609 116302 4.30% 95.60% 8.90% 91.00% 90.70% 0.50% 8.60% 32.20% 60.90% 6.70% 79.20% 20.70% 77.40% 8.30% 4.00% . 10.10% 86.90% 13.00% 19.20% 78.60% 2.10% 18.50% 2003 84697 80.7 2.26E+05 7.5 4.1 618 135441 3.60% 96.30% 10.00% 89.90% 92.50% 0.50% 6.80% 29.10% 64.20% 6.50% 79.40% 20.50% 88.70% 7.30% 3.90% . 0.00% 80.10% 19.80% 30.50% 68.40% 1.00% 21.00% 2004 60333 81.4 2.35E+05 7.1 4.8 617 144834 1.70% 98.20% 10.50% 89.40% 94.50% 0.80% 4.50% 28.10% 66.10% 5.70% 79.70% 20.20% 85.10% 6.80% 3.90% . 4.00% 85.20% 14.70% 20.30% 75.40% 4.10% 29.50% 2005 72986 82.1 2.93E+05 7.3 5.2 621 173683 0.90% 99.00% 13.90% 86.00% 93.50% 1.50% 4.80% 37.50% 54.60% 7.80% 66.40% 33.50% 55.20% 4.40% 3.30% . 36.90% 86.10% 13.80% 12.40% 64.60% 22.70% 29.80% 2006 25471 80.9 3.07E+05 7.9 5.3 622 182161 0.60% 99.30% 12.80% 87.10% 95.10% 1.80% 3.00% 41.90% 53.30% 4.60% 63.40% 36.50% 51.10% 3.30% 3.20% . 42.20% 89.70% 10.20% 10.30% 60.90% 28.60% 30.80% Total 504247 81 2.31E+05 8.3 4.4 610 129438 5.00% 94.90% 10.70% 89.20% 93.10% 0.80% 5.90% 35.30% 57.00% 7.50% 77.00% 22.90% 72.70% 10.30% 4.60% 0.00% 12.20% 85.90% 14.00% 23.60% 66.40% 9.60% 25.60%

46

Table III Coefficients Estimates for Fixed Utilities for Loans Are Current at t-1
Intercept OO OccType INV SEC SFR PropType Others LOW DocType Others Purchase Purpose CashOut NonCashOut AB RiskGradeType C Other CA State Other FICO (/1,000) LoanAmt(/1,000,000) FICO*LoanAmt(/1,000,000,000) Low FICO Indicator(FICO<550) Low Loan Amount Indicator (<100,000) Hybrid PropType Fixed 0.10175(0.01525***) Not Included -0.05562(0.01004***) Not Included 0.17152(0.02080***) -0.51047(0.05229***) 4.95227(0.80066***) -7.47467(1.29264***) 0.01397(0.02300) 0.08860(0.01344***) 0.0000 -0.11974(0.01594***) 1.50361(0.04617***) 0.98319(0.35605**) -1.21349(0.61526*) 0.00536(0.01183) -0.09043(0.01081***) 0.0000 0.08189(0.01791***) -3.4122(0.26509***) -1.94311(0.60581**) 3.42084(0.98521***) -0.01244(0.01412) 0.04024(0.0112***) 0.0000 -0.17531(0.02375***) 1.3295(0.07971***) 1.938(0.70453**) -2.43453(1.19331*) 0.03199(0.02469) -0.15642(0.01933***) 0.0000 0.02939(0.03068) 0.0000 0.0000 -0.00605(0.01694) 0.0000 0.0000 0.01237(0.01769) 0.0000 0.0000 -0.02924(0.03546) 0.0000 0.0000 0.0000 0.0000 -0.14192(0.01531***) -0.10032(0.03398**) 0.11755(0.01562***) 0.17652(0.02415***) 0.0000 0.0000 0.04263(0.00742***) 0.11942(0.01854***) 0.03533(0.01203**) 0.03376(0.01898) 0.0000 0.0000 -0.10239(0.01052***) -0.02235(0.02521) 0.0535(0.01166***) 0.09282(0.01678***) 0.0000 0.0000 0.16416(0.01638***) 0.05618(0.02913) 0.02994(0.02276) -0.02895(0.03361) -0.02122(0.01845) 0.04278(0.01726*) -0.01757(0.01301) -0.03713(0.01026***) -0.01178(0.01281) 0.0292(0.01097**) -0.0256(0.02175) -0.10108(0.01814***) Two Step MNP With DP and Wavelet Dlq60 UsingDP 0.0000 0.14741(0.01766***) -0.23658(0.07325**) 0.0000 Prepay UsingDP 0.0000 -0.08765(0.01246***) -0.08523(0.04564) 0.0000 Dlq60 0.64798(0.13988***) 0.0000 0.10564(0.01329***) -0.16436(0.06054**) 0.0000 Two Step MNP Prepay 0.0000 0.0000 -0.13415(0.02532***) -0.10949(0.08428) 0.0000

47

Table IV Coefficients Estimates for Fixed Utilities for Loans Are Delinquent at t-1
Dlq60 Intercept OO OccType INV SEC SFR PropType Others LOW DocType Others Purchase Purpose CashOut NonCashOut AB RiskGradeType C Other CA State Other FICO (/1,000) LoanAmt(/1,000,000) FICO*LoanAmt(/1,000,000,000) Low FICO Indicator(FICO<550) Low Loan Amount Indicator (<100,000) Hybird PropType Fixed -0.04198(0.01131***) 0.00068(0.02300) -0.11600(0.01537***) -0.05271(0.0132***) -0.0244(0.02352) -0.11688(0.03109***) 0.14934(0.02647***) 0.59468(0.39370) -0.80513(1.05809) 1.28523(1.68740) 0.04444(0.01789**) 0.04624(0.01521**) 0.0000 0.14995(0.11052) -0.06010(0.19319) -0.54973(1.38009) 0.37385(2.59033) 0.04080(0.02179) 0.07992(0.02691**) 0.0000 0.01751(0.02599) 3.06115(0.28184***) 2.54214(1.03546*) -4.35253(1.69628**) 0.02578(0.02370) -0.10615(0.01124***) 0.0000 0.167(0.03927***) 0.92074(0.36166**) -2.08619(1.04935*) 2.79457(1.72938) 0.05145(0.02076**) 0.05695(0.01703***) 0.0000 0.26538(0.02932***) 1.64623(0.24718***) -1.64137(0.92507) 2.04162(1.51109) 0.04224(0.01148***) 0.04538(0.02226*) 0.0000 -0.04468(0.06896) -0.12391(0.66947) -0.24567(2.22846) 1.49468(3.66717) 0.03735(0.04845) -0.12592(0.03659***) 0.0000 -0.00143(0.02815) 0.0000 0.0000 0.01708(0.03469) 0.0000 0.0000 0.15239(0.04016***) 0.0000 0.0000 0.00001(0.02929) 0.0000 0.0000 -0.02377(0.03906) 0.0000 0.0000 0.04666(0.06501) 0.0000 0.0000 0.0000 0.0000 -0.05967(0.01253***) -0.03793(0.03234) -0.01623(0.01410) -0.08702(0.02018***) 0.0000 0.0000 -0.18538(0.02055***) -0.19048(0.05228***) -0.08803(0.02545***) -0.22884(0.03469***) 0.0000 0.0000 0.08757(0.01751***) 0.05818(0.02117**) -0.05032(0.01465***) -0.04222(0.02642) 0.0000 0.0000 -0.0543(0.02638*) 0.07386(0.04458) -0.01554(0.0149) -0.10173(0.02327***) 0.0000 0.0000 -0.08088(0.01501***) -0.16197(0.02228***) -0.08288(0.02194***) -0.26508(0.02376***) 0.0000 0.0000 0.12879(0.02974***) 0.10083(0.08539) -0.01616(0.03373) 0.01731(0.05493) 0.02590(0.01694) -0.04907(0.01545**) 0.05002(0.05475) 0.03866(0.02615) 0.04901(0.01563**) 0.01612(0.01580) 0.02007(0.02004) -0.06313(0.01828***) -0.01637(0.03065) 0.00859(0.01426) 0.03641(0.041) 0.02736(0.03542) 0.01748(0.23277) 0.0000 0.04314(0.01945*) -0.12464(0.09725) 0.0000 Two Step MNP With DP and Wavelet De-noise Default UsingDP 0.0000 0.19774(0.03697***) -0.26153(0.12336*) 0.0000 Prepay -2.98535(0.16320***) 0.0000 0.28055(0.03053***) 0.28100(0.08879**) 0.0000 Dlq60 -0.00849(0.24793) 0.0000 0.04416(0.02145*) -0.10944(0.11014) 0.0000 Two Step MNP Default -2.4715(0.15963***) 0.0000 0.21019(0.02565***) -0.28477(0.05374***) 0.0000 Prepay -1.33773(0.40421***) 0.0000 0.3208(0.0447***) 0.46408(0.17948**) 0.0000

48

Table V Coefficients Estimates for Variable Utilities for Loans Are Current at t-1
Two Step MNP With DP and Wavelet De-noise Dlq60 Current LTV Incentive Type 1 Incentive Type 2 Incentive Type 3 Unemp Lag 1 of Slope Credit Curing Average Credit Curing Purchase*Refi Incentive 1 Interation BTW Incentive Type 1 and Purpose CashOut*Refi Incentive 1 NonCashOut*Refi Incentive 1 Purchase*Refi Incentive 2 Interation BTW Incentive Type 2 and Purpose CashOut*Refi Incentive 2 NonCashOut*Refi Incentive 2 Loan Amount(/1,000,000)*Incentive Type 1 Loan Amount(/1,000,000)*Incentive Type 2 FICO(/1000)*Incentive Type 1 FICO(/1000)*Incentive Type 2 FICO(/1000)*Average Credit Curing FICO(/1000)*Average Credit Curing*Incentive Type 1 FICO(/1000)*Average Credit Curing*Incentive Type 2 Dec, Jan, Feb Mar, Apr, May Season Jun, Jul, Aug Sep, Oct, Nov Age Age*Age(/100) Age Factors sqrt(Age) Age*Age*Age(/1000) Age*Fixed Age*Age(/100)*Fixed Age Factors*ProdType sqrt(Age)*Fixed Age*Age*Age(/1000)*Fixed Short Term HPA Medium Term HPA -0.19249(0.01153***) 0.00419(0.00065***) 0.32389(0.09162***) -1.16901(0.13147***) Not Included Not Included 0.59628(0.05808***) 0.41613(0.09377***) -0.02646(0.01537*) 0.00068(0.00125) 0.18276(0.06642**) -0.81122(0.09207***) Not Included Not Included 0.33934(0.07536***) 1.47141(0.07448***) 0.08099(0.02020***) 0.00839(0.00068***) 0.03626(0.00428***) -0.05420(0.00845***) Not Included Not Included Not Included Not Included 0.05263(0.02516*) 0.00554(0.00082***) 0.00251(0.00585) -0.00489(0.01408) Not Included Not Included Not Included Not Included -0.02884(0.00818***) 0.01085(0.00810) 0.05177(0.00476***) -0.12420(0.00808***) 0.03646(0.00737***) 0.01935(0.00710**) Not Included Not Included -0.02118(0.00522***) 0.0027(0.00576) 0.03347(0.00622***) -0.08121(0.01046***) 0.04508(0.01188***) 0.01253(0.00944) Not Included Not Included -0.03201(0.02282) 0.18278(0.02618***) -0.18791(0.04746***) -0.12735(0.01634***) 0.00661(0.00310*) 0.04168(0.00493***) -0.27924(0.01455***) -1.85202(0.58585**) 0.0000 -0.01238(0.00253***) -0.00493(0.00465) 0.0000 0.02261(0.00509***) 0.02329(0.00811**) 0.05064(0.02251*) 0.00195(0.03028) -0.49989(0.04220***) 0.65730(0.08398***) 4.99536(1.14915***) 0.12135(0.04620**) -0.67245(0.08382***) 0.0000 -0.11460(0.01524***) Prepay -0.60196(0.01830***) 0.21983(0.01399***) -0.28500(0.03846***) 0.08880(0.01104***) -0.00583(0.00116***) -0.02957(0.00817***) 0.12533(0.00753***) 1.51218(1.24872) 0.0000 0.00091(0.00564) -0.04402(0.00677***) 0.0000 -0.01333(0.01211) 0.05255(0.01506***) 0.08884(0.01891***) 0.11398(0.04232**) -0.27764(0.02146***) 0.42359(0.05736***) -1.60997(2.19738) -0.56882(0.05711***) 0.61108(0.08098***) 0.0000 0.03390(0.00581***) Dlq60 -0.0653(0.04197) -0.01154(0.02692) -0.1821(0.03624***) -0.12205(0.02216***) -0.00232(0.00331) 0.03199(0.00734***) -0.16639(0.00869***) -0.96413(0.34836**) 0.0000 -0.00612(0.00317) -0.01461(0.00816) 0.0000 0.01557(0.00626**) 0.02653(0.01378) 0.01307(0.02517) 0.07971(0.0412) -0.09521(0.05155) 0.5114(0.06472***) 2.59779(0.61611***) 0.03339(0.04174) -0.34312(0.05239***) 0.0000 -0.06756(0.00559***) Two Step MNP Prepay -1.70033(0.0504***) 0.17236(0.02306***) -0.23172(0.04927***) 0.19633(0.01977***) 0.00429(0.00396) -0.16824(0.00889***) 0.25888(0.02009***) -0.29367(0.63006) 0.0000 -0.0155(0.00268***) -0.02574(0.00713***) 0.0000 0.0077(0.00681) 0.0496(0.01645**) 0.18477(0.04108***) 0.06221(0.06882) 0.04847(0.03117) 0.1543(0.07335*) 2.77903(1.56788) -0.97545(0.12779***) 0.73062(0.10709***) 0.0000 0.04103(0.00754***)

49

Table VI Coefficients Estimates for Variable Utilities for Loans Are Delinquent at t-1
Current LTV Incentive Type 1 Incentive Type 2 Incentive Type 3 Unemp Lag 1 of Slope Average Credit Curing Purchase*Refi Incentive 1 CashOut*Refi Incentive 1 NonCashOut*Refi Incentive 1 Purchase*Refi Interation Incentive 2 BTW CashOut*Refi Incentive Incentive 2 Type 2 and NonCashOut*Refi Purpose Incentive 2 Loan Amount(/1,000,000)*Incentive Type 1 Loan Amount(/1,000,000)*Incentive Type 2 Interation BTW Incentive Type 1 and Purpose FICO(/1000)*Incentive Type 1 FICO(/1000)*Incentive Type 2 FICO(/1000)*Average Credit Curing FICO(/1000)*Average Credit Curing*Incentive Type 1 FICO(/1000)*Average Credit Curing*Incentive Type 2 Dec, Jan, Feb Mar, Apr, May Season Jun, Jul, Aug Sep, Oct, Nov Dt(/10) Time Staying in the State of DLQ Dt*Dt(/100) sqrt(Dt) Short Term HPA Medium Term HPA -0.03606(0.01203**) 0.04107(0.00881***) -1.39012(0.06036***) 0.08295(0.00564***) 0.90030(0.03292***) 0.03574(0.13641) -0.83679(0.13532***) -0.04998(0.01637**) 0.02902(0.01466*) -2.63344(0.12706***) 0.15479(0.01230***) 1.74950(0.05635***) -1.39336(0.30167***) -1.70977(0.40420***) -0.05111(0.02263*) 0.00074(0.01133) -1.10096(0.06915***) 0.08339(0.00605***) 0.68941(0.03365***) 0.21412(0.29734) 0.60201(0.31972) -0.03321(0.0127**) 0.0593(0.01214***) -1.61462(0.06979***) 0.09308(0.00739***) 1.04796(0.033***) -0.06393(0.15577) -0.97127(0.17728***) -0.04662(0.03491) 0.06298(0.02064**) -2.8194(0.08457***) 0.15938(0.00921***) 1.85136(0.03868***) -1.01243(0.57701) -2.76956(0.65363***) Two Step MNP With DP and Wavelet De-noise DLQ -0.14216(0.04504**) -0.22386(0.05260***) 0.15654(0.07967*) -0.36610(0.03646***) -0.00037(0.00331) 0.18782(0.00904***) 0.88268(0.21853) 0.0000 -0.00128(0.00699) 0.00648(0.01107) 0.0000 0.01814(0.01298) 0.00299(0.01852) -0.04850(0.05876) 0.18486(0.09896) -0.01004(0.07715) 0.15183(0.11707) -2.25629(0.36638***) 0.22974(0.02425***) DEFT -0.08994(0.05825) -0.70501(0.10194***) 0.43586(0.16798**) -0.27156(0.03961***) -0.02839(0.00402***) 0.39467(0.02967***) 0.03127(0.29089) 0.0000 0.04522(0.01638**) 0.06763(0.03059*) 0.0000 -0.05418(0.03657) -0.09336(0.05562) 0.03820(0.09986) 0.15974(0.17171) 0.08663(0.13549) 0.32462(0.24829) -2.97962(0.49946***) 0.70017(0.04563***) PPAY -1.30921(0.05935***) -0.00281(0.09493) 0.16836(0.14759) -0.13853(0.03246***) 0.00009(0.00394) 0.02777(0.01304*) -0.78982(0.58484) 0.0000 -0.03730(0.01112***) -0.07832(0.02418***) 0.0000 0.05792(0.02024**) 0.12813(0.04481**) 0.21867(0.06049***) -0.09684(0.11147) -0.06140(0.14327) -0.22334(0.22389) 0.55163(0.86150) 0.12009(0.03493***) DLQ -0.20872(0.05006***) -0.21414(0.05061***) 0.12479(0.09244) -0.4336(0.0505***) -0.00106(0.00552) 0.22684(0.01141***) 1.18817(0.23573***) 0.0000 -0.01091(0.00826) -0.02207(0.01758) 0.0000 0.03538(0.01251**) 0.02783(0.0284) 0.03421(0.04676) 0.14483(0.09406) -0.11426(0.07693) 0.29602(0.15014*) -2.8254(0.39161***) 0.26108(0.02665***) Two Step MNP DEFT -0.11898(0.10047) -0.54753(0.0752***) 0.3308(0.13543**) -0.22389(0.09369*) -0.04356(0.01019***) 0.37566(0.02542***) 0.7497(0.4344) 0.0000 0.02021(0.0129) 0.06507(0.01426***) 0.0000 -0.03061(0.02575) -0.10097(0.02712***) -0.01208(0.06425) 0.22272(0.14418) -0.12768(0.1064) 0.4464(0.19931*) -4.22319(0.69896***) 0.69872(0.03216***) PPAY -1.50392(0.14975***) -0.17743(0.06632**) 0.18464(0.10213) -0.15703(0.10319) 0.00336(0.00926) -0.00833(0.02249) -1.3698(0.54575*) 0.0000 -0.04164(0.01154***) -0.07757(0.02525**) 0.0000 0.05712(0.0233**) 0.11431(0.0513*) -0.05711(0.08661) 0.35157(0.17526*) 0.3319(0.12152**) -0.35023(0.17331*) 1.6757(0.98809) 0.10968(0.06926)

-0.13762(0.02678***) 0.0000 -0.07100(0.01048***)

-0.52017(0.06126***) 0.0000 -0.09278(0.01784***)

-0.08238(0.06461) 0.0000 -0.01817(0.01941)

-0.17772(0.03991***) 0.0000 -0.0828(0.0129***)

-0.50727(0.05483***) 0.0000 -0.11288(0.02189***)

-0.06852(0.08617)

0.0000 0.04096(0.03373) 0.00044(0.0398) 0.04302(0.02756) -1.37533(0.139***) 0.11016(0.01196***) 0.80786(0.07511***) -0.02685(0.38765) 1.18164(0.40399**)

50

Table VII Covariance Estimates for Stochastic Utilities for Loans Are Current at t-1
Covariance Two Step MNP With DP and Wavelet Two Step MNP

Covariance Dlq60 Dlq60 Prepay 0.69378(0.01672) 0.01035(0.01380) Prepay 0.01035(0.01380) 1.00000(0.00000) Dlq60 0.24051(0.01107) 0.0078(0.01164) Prepay 0.0078(0.01164) 1

Table VIII Covariance Estimates for Stochastic Utilities for Loans Are Delinquent at t-1
Covariance Covariance Dlq60 Dlq60 Default Prepay 0.35962(0.02362) -0.05090(0.01211) -0.03145(0.01551) Default -0.05090(0.01211) 0.48138(0.02824) 0.08926(0.04748) Prepay -0.03145(0.01551) 0.08926(0.04748) 1.00000(0.00000) Dlq60 0.5133(0.02619) -0.08415(0.02076) -0.08472(0.02405) Default -0.08415(0.02076) 0.62333(0.04604) -0.01115(0.0434) Prepay -0.08472(0.02405) -0.01115(0.0434) 1.0000 Two Step MNP With DP and Wavelet Two Step MNP

Table IX Variance Estimates for Fixed Utilities for Loans Are Current at t-1
Variances of Fixed Utilities Two Step MNP With DP and Wavelet Two Step MNP

Dlq60 Prepay

Using DP Using DP

0.153259944(6.91E-03) 0.656359448(1.33E-02)

Table X Variance Estimates for Fixed Utilities for Loans Are Delinquent at t-1
Variances of Fixed Utilities Dlq60 Default Prepay Two Step MNP With DP and Wavelet 0.03951(0.00385) UsingDP 0.00242(0.00031) Two Step MNP 5.69E-02(4.90E-03) 1.26E-03(3.41E-04) 0.362899459(8.57E-02)

Table XI Variance Estimates for Baseline Utilities for Loans Are Current at t-1
Variances of Baseline Utilities Fixed 228 327 PPPTerm12 PPPTerm24 PPPTerm36 PPPTerm60 Two Step MNP With DP and Wavelet 0.0000091600(0.0000036602) 0.0000137314(0.0000042567) 0.0000061965(0.0000015425) 0.0000068210(0.0000015700) 0.0000099266(0.0000035046) 0.0000286154(0.0000154714) 0.0000032741(0.0000006109)

51

Mortgage Default Process

Cured
or

Paid off
Default Default
Loss Booked Loss Booked

BK
FC Halts

BK Resolved Short Sale FC Sale

Delinquent Payment FC Begins FC Completed

Default

REO

Liquidation Completed
Loss Booked

Figure 1: Default Process

52
Deed In Lieu

For More than 60 Days Late

Cured Paid Off

FC Stops

Cash for Keys Default

Loss Severity Includes

* MVD * Interest Carrying * Other Expenses

FC = Foreclosure BK = Bankruptcy

Length of foreclosure time is a function of state laws.

Figure 2: Distribution of Prepayment, Default, and Delinquency Grands.

53

Baselines for Fixed Loans

1

The Extended Model The TwoStep Model 0 Baseline Utility 4 0 3 2 1

10

20

30 Age Month

40

50

60

Baselines for Hybrid 2/28 Loans

1

The Extended Model The TwoStep Model 0 Baseline Utility 4 0 3 2 1

10

20

30 Age Month

40

50

60

Baselines for Hybrid 3/27 Loans

1

The Extended Model The TwoStep Model 0 Baseline Utility 4 0 3 2 1

10

20

30 Age Month

40

50

60

Figure 3: Baseline Estimates for Fixed Loans, Hybrid 2/28 Loans, and Hybrid 3/27 Loans Given By the Two-Step Model and the Extended Model. 54

Baselines for Loans with 12month Prepay Penalty Window

2

The Extended Model 1 The TwoStep Model

Baseline Utility

3 0

10

20

30 Age Month

40

50

60

Baselines for Loans with 24month Prepay Penalty Window

2

The Extended Model 1 The TwoStep Model

Baseline Utility

3 0

10

20

30 Age Month

40

50

60

Baselines for Loans with 36month Prepay Penalty Window

2

The Extended Model 1 The TwoStep Model

Baseline Utility

3 0

10

20

30 Age Month

40

50

60

Baselines for Loans with 60month Prepay Penalty Window

2

The Extended Model 1 The TwoStep Model

Baseline Utility

3 0

10

20

30 Age Month

40

50

60

Figure 4: Baseline Estimates for Loans with Dierent Prepay Penalty Windows Given By the Two-Step Model and the Extended Model. 55

Termination and Performance Analysis - Subprime Loans of A Particular Originator

Loans Originated from 1998 to 2006 (As of 06/2006)
ALL, Prepayment
100.000% 20.000% 100.000%

The Extended Model with De-noised Prepayment Baseline and Accounted Heterogeneity: In Sample

ALL, Delinquency 60+ Days Performance

40.000%

36.000%

90.000%

18.000%

90.000%

32.000%

80.000%

16.000%

80.000%

28.000%

70.000%

14.000%

70.000%

24.000%

60.000%

12.000%

60.000%

20.000%

50.000%

10.000%

50.000%

16.000%

40.000%

8.000%

40.000%

12.000%

30.000%

6.000%

30.000%

8.000%

20.000%

4.000%

20.000%

4.000%

10.000%

2.000%

10.000%

0.000% 40 50 60 70 80 0 10 20 30

0.000%

0.000% 40 50 60 70 80

0.000%

10

20

30

D60plus Prediction

D60plus Actual

Pred. Survival

Actual Survival

Prepay Prediction

Prepay Actual

Pred. Survival

Actual Survival

Figure 5: The Extended Model: In Sample

ALL, Cumulative Prepayment
100.000% 100.000% 90.000% 90.000% 80.000% 80.000% 70.000% 70.000% 60.000% 60.000% 50.000% 50.000% 40.000% 40.000% 30.000% 30.000% 20.000% 20.000% 10.000% 10.000% 0.000% 40 50 60 70 80 0.000% 0 10 20 30 40 50 60 Pred. Survival Actual Survival Cum. Prepay Prediction Cum. Prepay Actual Pred. Survival

56

ALL, Cumulative Default

15.000%

100.000%

13.500%

90.000%

12.000%

80.000%

10.500%

70.000%

9.000%

60.000%

7.500%

50.000%

6.000%

40.000%

4.500%

30.000%

3.000%

20.000%

1.500%

10.000%

0.000%

0.000% 70 80

10

20

30

Cum. Default Prediction

Cum. Default Actual

Actual Survival

Data Source: LoanPerformance Database Fixed Income Research, Countrywide Securities Corp. Although the information included in this report has been obtained from sources that Countrywide Securities Corporation (CSC) believes to be reliable, we do not guarantee its accuracy or completeness. All computational information is hypothetical and subject to change without notice. CSC does not make any guarantee on returns of the investments and past performance is not indicative of future returns. The materials contained herein are being provided for informational purposes only and CSC makes no representation as to their accuracy or completeness. Assumptions underlying any computation or valuation materials are subject to change without notice. CSC may have acted as an underwriter, have a position, makes a market, purchase or sell the same on a principal basis or as agent in the securities discussed. Nothing herein is or shall be construed as an offer to buy or sell securities. CSC is a member of NASD/SIPC.

Termination and Performance Analysis - Subprime Loans of A Particular Originator

Loans Originated from 1998 to 2006 (As of 06/2006)
ALL, Prepayment
100.000% 20.000% 100.000%

The Extended Model with De-noised Prepayment Baseline and Accounted Heterogeneity: Out-of Sample

ALL, Delinquency 60+ Days Performance

40.000%

36.000%

90.000%

18.000%

90.000%

32.000%

80.000%

16.000%

80.000%

28.000%

70.000%

14.000%

70.000%

24.000%

60.000%

12.000%

60.000%

20.000%

50.000%

10.000%

50.000%

16.000%

40.000%

8.000%

40.000%

12.000%

30.000%

6.000%

30.000%

8.000%

20.000%

4.000%

20.000%

4.000%

10.000%

2.000%

10.000%

0.000% 40 50 60 70 80 0 10 20 30

0.000%

0.000% 40 50 60 70 80

0.000%

10

20

30

D60plus Prediction

D60plus Actual

Pred. Survival

Actual Survival

Prepay Prediction

Prepay Actual

Pred. Survival

Actual Survival

Figure 6: The Extended Model: Out Of Sample

ALL, Cumulative Prepayment
100.000% 100.000% 90.000% 90.000% 80.000% 80.000% 70.000% 70.000% 60.000% 60.000% 50.000% 50.000% 40.000% 40.000% 30.000% 30.000% 20.000% 20.000% 10.000% 10.000% 0.000% 40 50 60 70 80 0.000% 0 10 20 30 40 50 60 Pred. Survival Actual Survival Cum. Prepay Prediction Cum. Prepay Actual Pred. Survival

57

ALL, Cumulative Default

15.000%

100.000%

13.500%

90.000%

12.000%

80.000%

10.500%

70.000%

9.000%

60.000%

7.500%

50.000%

6.000%

40.000%

4.500%

30.000%

3.000%

20.000%

1.500%

10.000%

0.000%

0.000% 70 80

10

20

30

Cum. Default Prediction

Cum. Default Actual

Actual Survival

Data Source: LoanPerformance Database Fixed Income Research, Countrywide Securities Corp. Although the information included in this report has been obtained from sources that Countrywide Securities Corporation (CSC) believes to be reliable, we do not guarantee its accuracy or completeness. All computational information is hypothetical and subject to change without notice. CSC does not make any guarantee on returns of the investments and past performance is not indicative of future returns. The materials contained herein are being provided for informational purposes only and CSC makes no representation as to their accuracy or completeness. Assumptions underlying any computation or valuation materials are subject to change without notice. CSC may have acted as an underwriter, have a position, makes a market, purchase or sell the same on a principal basis or as agent in the securities discussed. Nothing herein is or shall be construed as an offer to buy or sell securities. CSC is a member of NASD/SIPC.

Termination and Performance Analysis - Subprime Loans of A Particular Originator

Loans Originated from 1998 to 2006 (As of 06/2006)
The Two-step MNP Model: Out-of Sample
ALL, Prepayment
100.000% 20.000% 100.000%

ALL, Delinquency 60+ Days Performance

40.000%

36.000%

90.000%

18.000%

90.000%

32.000%

80.000%

16.000%

80.000%

28.000%

70.000%

14.000%

70.000%

24.000%

60.000%

12.000%

60.000%

20.000%

50.000%

10.000%

50.000%

16.000%

40.000%

8.000%

40.000%

12.000%

30.000%

6.000%

30.000%

8.000%

20.000%

4.000%

20.000%

4.000%

10.000%

2.000%

10.000%

0.000% 40 50 60 70 80 0 10 20 30

0.000%

0.000% 40 50 60 70 80

0.000%

10

20

30

D60plus Prediction

D60plus Actual

Pred. Survival

Actual Survival

Prepay Prediction

Prepay Actual

Pred. Survival

Actual Survival

Figure 7: The Two-Step Model: In Sample

ALL, Cumulative Prepayment
100.000% 100.000% 90.000% 90.000% 80.000% 80.000% 70.000% 70.000% 60.000% 60.000% 50.000% 50.000% 40.000% 40.000% 30.000% 30.000% 20.000% 20.000% 10.000% 10.000% 0.000% 40 50 60 70 80 0.000% 0 10 20 30 40 50 60 Pred. Survival Actual Survival Cum. Prepay Prediction Cum. Prepay Actual Pred. Survival

58

ALL, Cumulative Default

15.000%

100.000%

13.500%

90.000%

12.000%

80.000%

10.500%

70.000%

9.000%

60.000%

7.500%

50.000%

6.000%

40.000%

4.500%

30.000%

3.000%

20.000%

1.500%

10.000%

0.000%

0.000% 70 80

10

20

30

Cum. Default Prediction

Cum. Default Actual

Actual Survival

Data Source: LoanPerformance Database Fixed Income Research, Countrywide Securities Corp. Although the information included in this report has been obtained from sources that Countrywide Securities Corporation (CSC) believes to be reliable, we do not guarantee its accuracy or completeness. All computational information is hypothetical and subject to change without notice. CSC does not make any guarantee on returns of the investments and past performance is not indicative of future returns. The materials contained herein are being provided for informational purposes only and CSC makes no representation as to their accuracy or completeness. Assumptions underlying any computation or valuation materials are subject to change without notice. CSC may have acted as an underwriter, have a position, makes a market, purchase or sell the same on a principal basis or as agent in the securities discussed. Nothing herein is or shall be construed as an offer to buy or sell securities. CSC is a member of NASD/SIPC.

Termination and Performance Analysis - Subprime Loans of A Particular Originator

Loans Originated from 1998 to 2006 (As of 06/2006)
The Two-step MNP Model: Out-of Sample
ALL, Prepayment
100.000% 20.000% 100.000%

ALL, Delinquency 60+ Days Performance

40.000%

36.000%

90.000%

18.000%

90.000%

32.000%

80.000%

16.000%

80.000%

28.000%

70.000%

14.000%

70.000%

24.000%

60.000%

12.000%

60.000%

20.000%

50.000%

10.000%

50.000%

16.000%

40.000%

8.000%

40.000%

12.000%

30.000%

6.000%

30.000%

8.000%

20.000%

4.000%

20.000%

4.000%

10.000%

2.000%

10.000%

0.000% 40 50 60 70 80 0 10 20 30

0.000%

0.000% 40 50 60 70 80

0.000%

10

20

30

D60plus Prediction

D60plus Actual

Pred. Survival

Actual Survival

Prepay Prediction

Prepay Actual

Pred. Survival

Actual Survival

Figure 8: The Two-Step Model: Out Of Sample

ALL, Cumulative Prepayment
100.000% 100.000% 90.000% 90.000% 80.000% 80.000% 70.000% 70.000% 60.000% 60.000% 50.000% 50.000% 40.000% 40.000% 30.000% 30.000% 20.000% 20.000% 10.000% 10.000% 0.000% 40 50 60 70 80 0.000% 0 10 20 30 40 50 60 Pred. Survival Actual Survival Cum. Prepay Prediction Cum. Prepay Actual Pred. Survival

59

ALL, Cumulative Default

15.000%

100.000%

13.500%

90.000%

12.000%

80.000%

10.500%

70.000%

9.000%

60.000%

7.500%

50.000%

6.000%

40.000%

4.500%

30.000%

3.000%

20.000%

1.500%

10.000%

0.000%

0.000% 70 80

10

20

30

Cum. Default Prediction

Cum. Default Actual

Actual Survival

Data Source: LoanPerformance Database Fixed Income Research, Countrywide Securities Corp. Although the information included in this report has been obtained from sources that Countrywide Securities Corporation (CSC) believes to be reliable, we do not guarantee its accuracy or completeness. All computational information is hypothetical and subject to change without notice. CSC does not make any guarantee on returns of the investments and past performance is not indicative of future returns. The materials contained herein are being provided for informational purposes only and CSC makes no representation as to their accuracy or completeness. Assumptions underlying any computation or valuation materials are subject to change without notice. CSC may have acted as an underwriter, have a position, makes a market, purchase or sell the same on a principal basis or as agent in the securities discussed. Nothing herein is or shall be construed as an offer to buy or sell securities. CSC is a member of NASD/SIPC.