Understanding Prepayment Risk

CFA Level I Fixed Income
#1

Don’t feel like I understand prepayment risk very well. Reading the chapter and some concepts seems to conflict. For example, prepayment risk is: “The uncertainty that the timing of the actual cash flows will be different from the scheduled cash flows as set forth in the loan agreement due to the borrowers’ ability to alter payments, usually to take advantage of interest rate movements”.

Based on this, I’m inferring that any change in interest rates will affect the way the mortgage loan holders will pay their loans back. This is confirmed in the CFAi book, and later on it says:

This prepayment risk has two components : contraction risk and extension risk , both of which largely reflect changes in the general level of interest rates.”

Contraction risk: The risk that when interest rates decline, the security will have a shorter maturity than was anticipated at the time of purchase because borrowers refinance at the new, lower interest rates.

Extension risk: is the risk that when interest rates rise, prepayments will be lower than forecasted because homeowners are reluctant to give up the benefits of a contractual interest rate that now looks low. As a result, a security backed by mortgages will typically have a longer maturity than was anticipated at the time of purchase.

So if we are a holder of an MBS, wouldn’t we want borrowers to pay back the loans sooner, before market interest rates changes?

But later on when discussing CMOs, PAC, and support tranches, CFAi book says “If the support tranches are paid off quickly because of faster-than-expected prepayments, they no longer provide any protection for the PAC tranches” (Pg. 495).

But isn’t that exactly what MBS holders want, is for borrowers to pay back as quickly as possible at the interest rates specified in the loan agreement, before interest rates change (which increases extension or contraction risk)?

I guess I’m either not interpreting the definitions right or there is something else I am missing. Does anyone underestand prepayment risk well?

It seems like the only way to eliminate the risks mentioned above is to not allow refinancing when interest rates change.

#2

Homeowners tend to refinance their mortgages when interest rates decrease.

You own and MBS with a coupon rate of 6% and rates drop to 3%. Do you really want to get your money back so that you can invest it at the current rate of 3% instead of the original rate of 6%?

#3

As an MBS owner, we want the homeowner to pay back their mortgage at the 6% rate rather than the 3%. We do not want the homeowner to refinance. So why not have just the mortgage owner pay back faster at 6%, rather than waiting longer, which exposes the MBS owner to interest rate risk? But the books says when the support tranches are paid off faster than expected, this is more risky. This is where the confusion comes from.

#4

Prepayment risk (particularly of the contraction risk variety) can be thought of as a special case of reinvestment rate risk. Any time you have intermediate payments (like in a bond of some type), the investor’s actual realized return will be based in part on the return they receive on reinvested interim payments.

Now let’s consider a callable bond. It’s likely to be called at a time when it is advantageous to the borrower/issuer (i.e. the company in this case). And that means when interest rates are lower. So in this case, the lender (the investor in the case of a bond) receives ALL their money at precisely the time when they’ll have to reinvest it all a lower rate.

Now let’s look at mortgages and mortgage-backed securities. In this case, you could think of prepayments (either in part or in whole) as a call by the borrower (in this case, the mortgage borrower). They’ll refinance and prepay the loan (i.e. exercise their call) when rates are low enough that they can refinance effectively (I know, there are other reasons for refinancing, but this is the major one in typical times).

So in this case, the lender (and by extension, the investor in the MBS that these mortgages are pooled is) is in the analogous case to the investor in a corporate bond - they end up having to reinvest MORE of their interim payments precisely when it most disadvantages them.