Measuring Mortgage-Backed Security Prepayments: A Comprehensive Guide

Mortgage-backed securities (MBS) are a type of asset-backed security that is secured by a mortgage or collection of mortgages. MBS are marketable and can trade at premiums, discounts or par value, depending on current market rates. The valuation of MBS begins with a projection of a subject security's cash flow, which includes scheduled principal payments, interest payments, and any prepayments. Prepayments are any payments made by borrowers that exceed the scheduled principal payment. Prepayment risk is a central factor in properly valuing MBS, and changes in interest rates account for most prepayment risk. However, other macroeconomic factors, such as unemployment rates and changing home valuation trends, also play a significant role in prepayment risk.

Prepayment risk

When a borrower takes out a mortgage, they typically agree to a fixed interest rate for the duration of the loan. However, if market interest rates drop significantly, the borrower may be incentivised to refinance their mortgage at a lower interest rate. This is where prepayment risk comes into play. When a borrower refinances their mortgage, the original loan is effectively paid off early, and the investor who purchased the MBS loses out on the future interest payments they were expecting to receive.

The impact of prepayment risk is particularly significant for MBS because mortgages often have long terms, such as 30 years, and it is common for them to be paid off much sooner. This makes it difficult to accurately predict the maturity of the MBS. To mitigate this risk, the concept of weighted average life (WAL) is introduced. WAL is a statistic that measures the effective maturity of an MBS by taking into account the impact of principal paydowns over the lifetime of the security.

Additionally, prepayment risk is correlated with rising home values. When property prices increase, homeowners may be more inclined to refinance their mortgages or sell their homes, leading to early repayment of the loan. This can further complicate the maturity predictions of MBS and impact the expected cash flows for investors.

Prepayment terms

The valuation of mortgage-backed securities begins with projecting the security's cash flow. The monthly cash flow from the underlying pool of mortgage loans includes scheduled principal payments (amortization), interest payments, and any prepayments. Prepayments are any payments made by borrowers that exceed the scheduled principal payment. Thus, the cash flow depends on the prepayment behaviour of the borrowers in the mortgage pool.

Mortgage-backed security (MBS) is a type of asset-backed security collateralized by a pool of residential mortgages. MBS can be traded through a broker and issued by a government-sponsored enterprise (GSE), an authorized federal government agency, or a private financial company. While MBS have attractive features, they also carry additional risks compared to plain vanilla bonds.

One of the challenges in the MBS market is the ability of homeowners to prepay their mortgages, which affects pricing. Prepayment risk refers to the possibility that the MBS buyer will receive interest income for a shorter period than expected, along with principal repayment. Prepayment forces the buyer to reinvest the principal, often at a lower rate of return. Changes in interest rates are a significant factor in prepayment risk, but they are not the only determinant.

Macroeconomic factors, such as unemployment rates and changing home valuation trends, also play a crucial role in prepayment risk. For instance, in a robust economy with rising home prices, homeowners may opt for a cash-out refinance, resulting in prepayment. Conversely, during challenging economic times, rising unemployment can lead to homeowners defaulting on their mortgages or choosing to move or face foreclosure.

To manage prepayment risk, the concept of weighted average life (WAL) is introduced. WAL is a measure of the effective maturity of an MBS and is calculated by multiplying the date of each payment (expressed as a fraction of years or months) by the percentage of the total principal paid off at that date and then summing these results. WAL helps to visualize the impact of principal paydowns over the lifetime of the security.

Prepayment rates

The prepayment risk is influenced by various factors, including current market interest rates and home values. When interest rates drop, borrowers are more likely to refinance their mortgages, resulting in investors in the MBS market losing future interest income. This dynamic creates an inverse relationship between mortgage rates and MBS prices. As mortgage rates increase, MBS prices tend to decrease, and vice versa.

The valuation of MBS begins with projecting the cash flow of the underlying security. This cash flow includes scheduled principal payments, interest payments, and any prepayments made by borrowers. Prepayments are any payments that exceed the scheduled principal amount. Therefore, the cash flow is dependent on the prepayment behaviour of the borrowers in the mortgage pool.

Understanding prepayment rates and the associated terminology is crucial for participants in the MBS market. It enables efficient risk-based pricing, evaluation of relative value within the MBS sector, and effective hedging and management of prepayment and credit risk exposure. Prepayment risk is a significant consideration when investing in MBS, and it can impact the overall yield and return on investment.

Prepayment assumptions

One commonly used prepayment assumption is the Constant Prepayment Rate (CPR) or Conditional Prepayment Rate. The CPR assumes that the percentage of the principal balance prepaid during a given year remains constant. This method offers analytical convenience as it provides a single consistent rate for each year, making it easier to compare quoted yields across different prepayment assumptions. The Public Securities Association's (PSA) prepayment benchmark model is another widely recognised standard. The PSA model is based on the assumption that the monthly prepayment rate gradually increases as a mortgage pool ages. It suggests a starting CPR of 0.2% for the first month, increasing by 0.2% each subsequent month up to 30 months, and a CPR of 6% for months 30 to 360.

The Federal Housing Administration (FHA) experience method is another approach that utilises historical data on the actual incidence of prepayment on mortgage loans. While the FHA method provides realistic and historically validated assumptions, it can be challenging due to the frequent updates and the potential for confusion in the secondary mortgage market.

It is worth noting that prepayment risk is an essential consideration in the context of MBS. Prepayment risk arises when borrowers repay loans early, affecting cash flows and bond valuations. There are two primary types of prepayment risk: contraction risk and extension risk. Contraction risk refers to the possibility of interest rates declining, leading to homeowners refinancing at lower rates. On the other hand, extension risk is the risk of rising interest rates resulting in lower-than-expected prepayments.

Prepayment behaviour

One of the primary drivers of prepayment behaviour is the change in market interest rates. When market interest rates decline, borrowers may be incentivised to refinance their mortgages at lower interest rates. This behaviour is often observed when the difference in interest rates is significant, as it provides borrowers with an opportunity to reduce their overall interest burden. For example, consider a homeowner who takes out a mortgage with a 15% interest rate. If the market interest rate drops to 10% within a few years, the homeowner may choose to refinance their mortgage at the lower rate, resulting in potential savings over the life of the loan. In this scenario, the lender faces prepayment risk, as they will forego the expected interest income at the higher rate.

The financial situation of borrowers also plays a role in prepayment behaviour. Some borrowers may experience improved financial circumstances, such as salary increases or bonuses, which could motivate them to make additional payments towards their mortgage principal. This behaviour can shorten the loan term and reduce the total interest paid over time. On the other hand, borrowers facing financial constraints or unexpected expenses may opt for prepayment penalties to access additional funds.

Individual preferences and financial goals also influence prepayment behaviour. Some individuals may prioritise becoming debt-free sooner, leading them to make extra payments whenever possible. Others may prefer the stability of adhering to the scheduled payment plan to maintain predictable cash flow. Additionally, the structure of the mortgage, such as the presence of prepayment penalties or refinancing fees, can impact a borrower's decision to make prepayments.

Understanding prepayment behaviour is essential for participants in the residential mortgage-backed securities market. It allows for efficient risk-based pricing and facilitates the evaluation of relative value within the MBS sector. By considering historical prepayment trends and market conditions, investors can make more informed decisions regarding the valuation and risk profile of mortgage-backed securities.

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