What does the Public Securities Association (PSA) benchmark assume about the conditional prepayment rate (CPR) of a 30-year mortgage?

The Public Securities Association (PSA) benchmark is a standard used in the mortgage-backed securities market that establishes assumptions about mortgage prepayment behavior. The benchmark specifically assumes that the conditional prepayment rate (CPR) of a 30-year mortgage begins at a lower level and increases systematically over time.

In the correct choice, the CPR starts at 0.2% per month and increases by 0.2% each month until it reaches 6% in month 30. This staging reflects the typical behavior of borrowers; initially, fewer borrowers are likely to refinance or pay off their loans quickly. However, as economic conditions change—such as declining interest rates or increasing homeowner equity—more borrowers may choose to refinance, leading to increased prepayments over time. This method of modeling is practical in evaluating the cash flows of mortgage-backed securities.

This gradual escalation in prepayment assumptions allows investors to better understand potential changes in expected cash flows, providing a framework for assessing risk and return on mortgage-backed investments. The PSA benchmark is widely used because it offers a more realistic depiction of borrower behavior than a constant rate model, recognizing that prepayment rates tend to fluctuate based on market conditions and individual borrower decisions.