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This paper studies the impact of mortgage curtailment behaviors on the subsequent default and prepayment performance. Although curtailment is not a popular event in the western countries, it is the dominant form of prepayment in Asia and other high saving rate regions. Using a sample of loan-level mortgage performance records from Taiwan, the results of the multinomial logit regressions indicate that curtailment is one of the most significant factors in predicting future default and prepayment probabilities of a seasoned mortgage pool. Mortgages with past curtailment are estimated to be 85% less likely to default and 23% more likely to prepay during the remaining life than a mortgage without any curtailment. Hence, ignorance of past curtailment records could lead to biased projection of default and prepayment and, hence, the pricing and hedging of a seasoned mortgage-backed security. By collecting and incorporating curtailment information, investors could more accurately estimate the fair market value, disclose risk-based capital, and perform effective hedging of a particular mortgage portfolio.

A mortgage loan is a debt contract that is secured by a real property. The borrower obtains a loan at origination and promises to repay at a fixed amortization schedule. At each point in time during the amortization period, the borrower has the right to choose among four payment actions: scheduled payment, complete prepayment, default, and curtailment. Much of the literature in mortgage finance considers a mortgage contract embedded with default (put) and prepayment (call) options for mortgagors.2 Default means that the borrower exercises the put option by selling the collateralized house to the lenders at the price equal to the unpaid principal balance (UPB) of the mortgage loan. The prepayment option gives the borrower the right to buy the loan back from the lender at the price equal to the UPB. The distinct difference is the fact that default only happens at the payment due dates, while a partial or complete prepayment can take place at any time before the maturity date. The past delinquency history of the pool or similar loans is a key indicator of the future default risk. Pools with a high past delinquency rate are likely to experience high future default rates. As a result, the investor would require a higher return for pools with high delinquency records. When securitizing a seasoned pool of mortgages, an issuer would usually exclude loans with past delinquency records in order to realize a good sales price. Curtailment refers to the event that a borrower makes a larger than scheduled periodical mortgage payment. The extra amount paid will be used to reduce the UPB of the mortgage. Although curtailment may not be a popular event among the western countries, it is recognized as the dominant form of prepayment in some regions with high saving rates, such as the Asian markets. In those countries, when a household receives extra income, such as a year-end bonus, partially repaying the outstanding debts is always a high priority alternative way of using the money. This behavior is consistent with the high savings rate observed in these regions. As the mortgage market in those regions matures and becomes more competitive, there is an increasing need to understand the impact of curtailment. The rest of the paper is organized as follows. The next section reviews relevant literature. Section 3 introduces the model and hypotheses regarding the impact of curtailment on future default and prepayment. The Section 4 presents the sample data and the econometric model applied in the empirical analysis. The Section 5 reports and interprets the regression results and their implications. The Section 6 concludes our study.

This paper contends that the mortgage curtailment reveals critical information regarding the future performance of the mortgage during its remaining life. The empirical study using a Taiwan mortgage sample provides strong support to our hypotheses. That is, past curtailment indicates low subsequent default rates and high subsequent prepayment rates. The magnitude of the impact appears to be quite substantial. The differential performance indicated by the curtailment can substantially affect the mortgage security’s value and risk. For transaction purposes, mortgages with past curtailment tend to have shorter expected effective remaining life and much lower default losses. Such loans favor the PO strip investors while providing lower value to the IO strip investors. As the design of mortgage securities is getting more complicated, the additional accuracy in the estimation of prepayment and default becomes more critical for mortgage portfolio investors. Although curtailment may not be a popular action of US borrowers, it is frequently observed among Asian mortgages. With relatively long housing tenure, curtailment is the dominant form of prepayment in those regions, such as Taiwan. As there is an increase in the volume of securitization activities from these regions, there needs to be increasing attention by global mortgage securities investors to the information conveyed by historical curtailment behavior. Our findings also have significant implication associated with the newly released Basel II risk-based capital rule. It indicates that internal rating based minimum capital could be significantly biased in the absent of the curtailment information. For mortgage portfolio mangers, the accuracy of the hedging strategies would also be heavily affected by the curtailment history. For this type of application, the impact of curtailment would be relevant to even the deeply seasoned mortgage pools. In summary, this paper is the first attempt to investigate the effect of curtailment information embedded in seasoned mortgages. As more and more MBSs issued from the regions with high curtailment rates are traded on the global capital market, more in depth research towards this issue using data from different locations and different mortgage product types is highly encouraged. To gain more comprehensive insights into the curtailment behavior, this paper can be extended in at least two directions. First, following Fu (1997) more research about the predictability of the probability and size of future curtailment can further enhance the richness of the mortgage performance and pricing model. It would allow investors to differentiate borrowers with different tendency to curtail at the time of mortgage origination and more accurately risk price the contract. Second, following Chinloy (1993), further attempt to investigate the reason behind borrower’s incentive to curtail can add a lot value to the mortgage industry. By collecting the average curtailment rates of different cities or countries, one would be able to investigate into the incentives why borrowers curtail. Being able to understand the reason why people curtail their mortgages could greatly help the lenders better customize mortgage products to the specific borrowers.