Study On The Prepayment And Optimal Penalty Of The Residential Mortgage

The prepayment of residential mortgage may bring up unexpected operational risks, reduce potential interest income, so the commercial banks have to take serious steps to forecast and control the prepayment risk. The rising interest rate spurred the borrowers to prepay their mortgages after 2004, which had adverse impact on the risk management of domestic banks. In this thesis, I combined the foreign and domestic academic achievements to analyze the prepayment conduct and prepayment penalty.My thesis is composed of six parts. The first part is the introduction of this paper and it gave a brief introduction of the background information and the academic importance of this topic. Then it concluded the negative influence mortgage prepayment may have on the lending banks.In the second part,â… reviewed the foreign and domestic academic achievements of prepayment of the residential mortgage, including the prepayment models, option theory and the statistic models. Then I took a review on the domestic literatures of the prepayment penalty and the methods to justify the existence of the optimal penalty to maximize the total social welfare.The third part analyzed the main influence factors on prepayment decision of the domestic and foreign borrowers respectively. Difference of the influence factors attributes to the different economic development, habits and customs, as well as the social background. The increase of income is the major influence factor on the domestic borrowers, as the refinancing incentive for foreign borrowers.The fourth part introduced the prepayment management experience of other countries. The financial institutions of America have been transferring the prepayment risk of mortgages through the most developed secondary market of the world. The innovation of mortgage products and the related regulations have reduced the prepayment of Dutch borrowers.In the fifth part, firstly I introduced the term structure of the prepayment penalty and the different impact it may have on the prepayment restrains. The following part gave a general review of the DD model (1983), which created an analytical framework by utility function and the general equilibrium. Similarly, this paper has utilized the utility function and general equilibrium to analyze the behavior of borrowers and proved that the marginal rate of substitution of the interest rate and the penalty for both borrower and the bank are identical, which means a Pareto Optimality can be reached when lending bank collects different optimal penalty according to difference market interest rates.The last part of this paper has gave several advice on the prepayment risk management of the domestic banks, including formulating justifiable penalty, establishment of the mortgage secondary market and the guarantee system, also the innovation of mortgage products and credit information system.