Many different types of securities, such as agency and corporate debentures, can be called by the issuer when market conditions favor refinancing a particular issue. Mortgage-Backed Securities (MBS), however, are unique among fixed-income securities containing embedded options. Unlike callable bonds where the refinancing decision rests with a single professional and the entire issue is called, the call options for the mortgages backing MBS pools are controlled by numerous individuals that have unique financial conditions and varying degrees of financial sophistication and awareness. This makes the analysis of MBS different than that of other classes of fixed-income securities, and influences both how investors value and trade securities and lenders originate loans and hedge their pipelines.
This article will discuss the nature of prepayments, addressing both the different forms of prepayment activities and why individuals do (and don’t) prepay their loans.
Decomposing Payments and Prepayments
A “prepayment” can be defined as the early or “unscheduled” return of principal to the bondholder. Keep in mind that since mortgages are structured to pay down over their term, prepayments must be accounted for and measured separately from amortizations or “scheduled” principal payments. This generally doesn’t impact the analytics for relatively new loans, given how long-term amortizing assets such as mortgages are structured.
Before examining prepayments, it is helpful to investigate the nature of mortgage payments and the composition of the cash flows. When a fixed-rate loan is originated, the borrower’s payment is determined for the life of the loan. However, the division of the payments between interest and principal evolves over time. Early in the loan’s life, most of the monthly payment is devoted to paying interest, with a relatively small portion of the payment directed to principal (which reduces the loan’s balance). As the loan ages or “seasons” and the amount of principal decreases, the interest component of the payment declines, since there is less principal throwing off interest; as the payment is fixed, however, the portion of the payment devoted to principal steadily increases. The illustration below shows the payments (total, principal and interest) over time on a $200,000 loan with a 4.0% note rate. Although the payments stay constant at a little over $950 per month, the interest component of the payment steadily declines from $667/month (or roughly 70% of the payment) and equals the amount of principal around month 155. By contrast, the principal payment grows in magnitude until it comprises virtually the entire payment by month 360. This highlights the fact that scheduled principal grows in importance over time, and indicates why prepayment analysis on older pools requires a separate accounting for scheduled and unscheduled principal in order to accurately measure and assess prepayments. (Some analysis measures the “runoff rate,” or the rate at which all principal pays down over time. While much simpler to calculate, effectively commingling scheduled and unscheduled principal payments gives an increasingly distorted view of prepayment experience as the pools age.)
Mortgage prepayments are attributable to a number of different behaviors. Housing “turnover’ represents the fairly steady and predictable activities associated with home sales. These events include normal trade-up and downsizing decisions, relocations, sales resulting from divorce, and insurance payments on structures destroyed by fire and natural causes. They also include more nebulous phenomena such as credit events, including both outright foreclosure and home sales by delinquent borrowers who still have equity in their property (and can capture it net of costs by selling the property). Turnover is fairly steady and consistent over time, and is not highly rate-sensitive. Alternatively, “refinancing” takes place when borrowers remain in their properties but replace their existing loan with a new obligation. Refinancings (or “refis”) can be further divided into “rate and term refis” (where the loan balances remain substantially unchanged but the new loans have reduced interest rate) and “cash-out refis,” where the borrower monetizes excess equity in their homes by taking larger loans. Both types of refinancing are rate-dependent, meaning that refi activity picks up substantially as interest rates (and, by implication, mortgage rates) decline. Mortgages with note rates that are around or lower than the current mortgage rate will generally experience limited refinancing activity, and the bulk of prepayment activity will represent the fairly regular activities associated with turnover. Loans with relatively high rates (or, to borrower from the option markets, “in the money” loans) can experience very rapid increases in prepayment speeds resulting from a surge in refinancing activity.
Moreover, the correlation between interest rates and refinancing activity (and, thus, prepayment speeds) strongly influence investment returns on MBS and make their price performance very difficult to predict and hedge.