ELECTIVE MORTGAGE PREPAYMENT - TERMINATION AND CURTAILMENT

Mortgage-prepayment risk underlies the structuring of mortgage-backed derivative securities, such as tranched real estate mortgage investmen t conduits. This prepayment comes either from mortgage termination or from curtailment, where the borrower retains the existing mortgage and prepays a portion. There are differences in cash flows from the two t ypes of prepayment. In termination, the loan disappears from a pool, a nd the scheduled payment to investors in the pool is reduced. In curta ilment, the loan survives, and the scheduled payment is unchanged but the term is reduced. There are implications for structuring mortgages and derivative securities. The prepayment decision is embedded in an i ntertemporal household utility maximization framework where choices ar e made between refinancing, making the regular payment, default or cur tailment. Empirical results are presented for Government National Mort gage Association (GNMA) pools, and an algorithm is presented that sepa rates the termination and curtailment components, facilitating the dev elopment of derivative securities.