Assume that interest rates in the year 2010 decrease below historical averages. They continue their downward trend for years 2011 and 2012. In which year would a MBS be least likely to be experience high rates of prepayment? A) 2012. B) 2010. C) 2011. D) 2013.
d) 13?
C. 2011 The term is something burnout. Prepayment burnout maybe?
need two more people to select A and B each. =) Then we’ll have an equal probability distribution.
Oh yea…4got about burnout…now that i think bout it… i want to say c…
A. I got this wrong on SchweserPro. Maybe i got it wrong again.
i thought the burnout thing happens when rates go down and then up and then down again, so the 2nd time rates fall, nobody refinances because they did the 1st time around. here, since rates drop and drop more, i’ll guess 2010- maybe right when rates go below historical it takes people a bit of time to refi and as rates keep going down, you’d see more refis? 2013 would seem right if you knew interest rates would kick back up, but you just don’t know given the info here, so not sure i’d feel good about that answer. either that our you tell me typical refi burnout happens in 1 or 2 or 3 yrs or something random like that… definitely don’t remember reading that.
i am now confused and going to call it a day…
g’nite ppl…
Dancingqueen, you certainly did remember what the right answer was. Your answer: D was incorrect. The correct answer was A) 2012. In a mortgage-backed security (MBS), whether a mortgage is called depends on the path of previous interest rates. If rates have been on a downward trend, then fewer mortgages will be refinanced as the trend continues because homeowners that have wanted to refinance will have already done so. Thus fewer mortgages will be refinanced in the year 2012 than in the earlier years. ***** I feel that since the downward trend is continuing, people would still refinance their MBS’s even in 2012! And in 2013…we might see a slowdown , if the interest rate is high or low. Why is is 2012? I don’t get it. I can understand 2011, because the interest rates are still going down… Just looked up this thing again from the CFAI text. On page 176, it says “Those who want to benefit by taking advantage of the refinancing opportunity will have done so already when the mortgage rate declined for the FIRST TIME.” First time here would be 2011. So people are least likely to re-finance in 2012. But the textbook doesn’t cover this particular path of arriving at the interest rate. Anyway, the key word is “FIRST TIME”.
D… Those who wantes to refinance and take advantage of lower rates would have done so by the time 2013 rolls around. its better to burn out…then to fade away Def Leppard…circa 1981
Bad question… by that explantion…2011 would be out of the question too as 2010 would have captured all those who wanted to refi. Terrible question…the pt is to understand prepayment burnout.
I don’t like this question. I viewed first time as 2010.
^^ Agree with both you guys. Hopeless question.
garbage question, quality insertion of neil young there jb.
In the real world you would have to know the actual interest rates. I would have guessed A, but you really can’t know without the numbers. If they were dropping really rapidly. Say dropping 5% a year, someone who refinanced in 2010 might be economically justified in refinancing in 2012 again. The decrease in your mortage payment would have to offset the refinancing fees (maybe $2,000+), which is no easy feat. Most people look at this only from the cash flow perspective, which isn’t correct economically. But if the rates were undergoing a gradual decline most people would refinance when rates dropped enough to justify it, but probably not again if rates dropped just a little further. For example, if your original mortgage was at 8% in 2009 and rates fell to 6% in 2011 you might refinance. If they then fell further to 5% in 2012 you most likely wouldn’t refinance again. The answer may lie in the fact that the interest rates fell below the HISTORICAL AVERAGE in 2010. This would mean that mortgage holders knew rates were low compared to the average and wouldn’t be expecting further decreases in rates, so most are going to take advantage of the refinance in 2010 and if not by then definitely in 2011. By 2012 most would have already taken advantange. Because markets work pretty well nobody can tell future rates. If they could they would wait until 2012 of course. As everybody else has mentioned though, I don’t think you will get a crappy question like this on the exam.
could this question be any more vague??
Ignoring the path for this question: is there a general rule of how far interest rates have to fall to make it worth while for people to re-fi? I understand it depends on the size of the mortgage, etc., but I mean ball park. 0.5%? 1%? 2%? Just curious because I remember a Schweser question where rates fell 0.25% and it said that was not enough. I’m just not sure where the actual crossover is. Thanks!
It runs in my mind that it is around 2% as a rule of thumb, but I could be wrong.