PSA Model

The PSA Model (also known as the 'Public Securities Association Prepayment Model') is an industry-standard benchmark used to estimate the speed at which homeowners are likely to pay off the mortgages within a mortgage-backed security (MBS). Homeowners prepay their loans for various reasons—selling their house, refinancing to a lower rate, or tapping into home equity. This prepayment activity is a massive variable for investors because it determines how quickly they get their principal back. Faster or slower-than-expected prepayments can dramatically alter the cash flow stream of an MBS, which in turn affects its yield and overall value. The PSA model doesn't predict the future, but it provides a standardized “speedometer” (e.g., 100 PSA, 200 PSA) that allows investors to compare different MBS products on an apples-to-apples basis and analyze the potential impact of prepayment risk.

The model's elegance lies in its simplicity. It establishes a baseline speed and then measures everything else relative to it.

The heart of the model is the 100 PSA speed, which serves as the fundamental baseline. It’s a simple, two-stage assumption about how prepayments will occur over the life of a new mortgage pool:

• The Ramp-Up: For the first 30 months, the model assumes the annual prepayment rate starts low and grows steadily. It begins at 0.2% in the first month and increases by 0.2% each subsequent month. This reflects the “seasoning” process, as new homeowners are less likely to move or refinance immediately after taking out a loan.
• The Plateau: After month 30, the prepayment rate is assumed to hit a ceiling and remain constant at 6% per year for the rest of the mortgage's life.

Once you understand the 100 PSA baseline, interpreting other speeds is straightforward. They are simply multiples of the benchmark.

• A 200 PSA reading means prepayments are assumed to happen at twice the 100 PSA rate. During the ramp-up, the rate would increase by 0.4% each month (0.2% x 2), and the plateau would be a constant 12% per year (6% x 2).
• A 50 PSA reading means prepayments are assumed to occur at half the 100 PSA rate. The ramp-up would be 0.1% per month (0.2% x 0.5), and the plateau would be 3% per year (6% x 0.5).

This system provides a quick, standardized language for discussing and comparing prepayment speeds. A higher PSA number signals faster expected prepayments, meaning an investor will likely receive their principal back sooner.

For a value investor, the price you pay determines your return. The PSA model is crucial because prepayment speed radically changes the value proposition of an MBS, particularly when dealing with a Premium Bond or a Discount Bond.

How quickly you get your money back can either make or break your investment.

• For a Premium Bond: Imagine paying $110 for a bond with a $100 face value to capture its juicy, high-interest payments. In this case, fast prepayments (a high PSA) are your enemy. You get your $100 principal back sooner than expected, which cuts short the time you can collect those above-market interest payments. This accelerates your premium loss and crushes your actual yield-to-maturity. This is a classic example of reinvestment risk—being forced to reinvest your capital at lower prevailing interest rates.
• For a Discount Bond: Now, imagine paying just $90 for that same $100 bond. Fast prepayments (a high PSA) are your best friend! You receive the full $100 principal back sooner than planned, which means your $10 gain is realized much more quickly. This provides a handsome boost to your overall yield.

Understanding PSA helps a value investor avoid overpaying for premium securities in a falling-rate environment and spot potential opportunities in discounted ones.

While powerful, the PSA model is just a standardized assumption. It is not a prediction. Real-world prepayments are messy and influenced by many factors the simple model ignores:

• Economic Health: In a booming economy with rising home prices, people may use “cash-out” refinances, boosting prepayments even if rates aren't falling.
• Rate “Burnout”: After a major refinancing wave, the remaining mortgage holders are often those who are unable or unwilling to refinance. Prepayments can then slow dramatically, even if rates fall further.
• Borrower Psychology: Human behavior is never perfectly predictable.

A savvy value investor uses PSA speeds as a critical input for analysis, not a final answer. They stress-test their assumptions by considering what might happen if prepayments come in much faster or slower than the market expects. This is where the hunt for a margin of safety comes in—buying an asset at a price that offers protection even if the future doesn't unfold exactly as the models suggest.