Cash Flows and Prepayment Risk
Prepayment risk is the risk that a borrower will repay the mortgage before its due date. Mortgages can usually be prepaid at any time without penalty.
Two Types of Prepayment Risk
- Contraction Risk: This is the risk that the investor (holder of the fixed income security) is forced to re-invest for a lower return following refinancing of mortgages in response to declining interest rates. The contraction risk increases as the interest rates decline. This is because as interest rates decline, the prepayments increase.
- Extension Risk: Inability of an investor to re-invest principal at higher rates following pro-longed rising interest rates because mortgage borrowers opt not to refinance (which extends the average life of mortgages in the asset pool). When interest rates are rising, the borrowers are less likely to prepay. So, the investor's capital is locked in the securities at a lower rate and they cannot invest this capital in higher-interest instruments.
Variables that Impact Prepayment Risk
- Mortgage Rates: In the event that mortgage rates drop far enough below the security's WAC, then borrowers are likely to refinance.
- Interest Rate Path: The trend in interest rate changes will impact prepayment patterns.
For example, if interest rates follow a pattern of dropping, then increasing, the refinancing will steadily decline as most borrowers are likely to become "burned out" (that is they refinanced following the initial rate drop and subsequent rate drops are not sufficient to warrant another refinancing).
Understanding the interest rate path is critical for evaluating MBS.
- Mortgage Characteristics: The mortgages in the security pool will all be different from one another (to varying degrees) and these differences will result in different refinancing behaviors.
- Seasonality: Real estate sales tend to be higher in the spring and summer, so prepayment may be higher during these months.
- Economic Climate: Real estate turnover tends to be higher during periods of economic expansion.
