Propensity Is Key to Applied Financial's Prepay Analysis.

New York -- Mortgage servicers have a lot of tools to manage the credit risk inherent in their loan portfolios, but at least one expert thinks they need to know more about the prepayment risk inherent in each loan.

Applied Financial Technology, a San Francisco-based analytics firm, offers a prepayment propensity score that functions much like a credit score, only it focuses on each loan's risk of refinancing instead of defaulting. Prepay scores allow lenders to distinguish the risk between otherwise similar loans.

Michael Bykhovsky, president and CEO of AFT, said the company's prepayment propensity score identifies which loans have the highest propensity to prepay based on factors other than interest rates. With more and more loan level data becoming available, this allows lenders, servicers and investors to calculate the value of MSRs more precisely, he said. It also allows some big lenders to "cherry pick" portfolios, selling off loans with less desirable propensity characteristics.

Mr. Bykhovsky told MSN that historically the economic value associated with prepayment risk has been overlooked in the mortgage market. That stands in stark contrast to the "risk-based pricing" associated with default risk factors.

"It is a complex risk to manage and understand. Most of the bankers have been trained to deal with issues of credit and various impacts from accounting measures," he said.

In fact, Mr. Bykhovsky says that accounting rules play too large a role in the management of mortgage servicing rights.

"The accounting standards, with their impact on servicing rights, drive a lot of bad decision making," he said. "There is a total disconnect between accounting and economics when you are measuring ...