Rise of the Machines: Application of Machine Learning to Mortgage Prepayment Modeling

Key to the valuation of agency residential mortgage-backed securities (MBSs) is the modeling of voluntary prepayment and default behaviors of the underlying borrowers in the mortgage pool. The proliferation of pool- and loan-level data coupled with access to advanced machine learning algorithms has opened the door to the application of machine learning to mortgage prepayment modeling. The modular prepayment model, one that relies on defined functions to predict mortgage prepayment, has dominated the MBS market nearly since its inception. However, machine learning models are beginning to make inroads and, in some cases, are replacing traditional modular prepayment models. The modular and machine learning model differ in the following ways: In the case of modular prepayment models, either added or multiplicative, the modeler defines the functional form of each feature as well as the “tuning” of the parameters passed to each. Machine learning or “second generation” mortgage prepayment models differ in the sense that the modeler “tunes” the hyperparameters that determine the bias variance tradeoff while the machine determines the functional form of each feature of the model. In this article, the authors propose a machine learning mortgage prepayment model using a boosted gradient classifier, trained at the loan level and generalized to the pool level. A gradient boosted classifier is a tree-based model using an ensemble of weak learners to create a strong committee for prediction.