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) 2010. B) 2012. C) 2011. D) 2013.

D? year 2013. Since most of the mortgage owners would have already prepayed their loans.

I would go with D as well, but what a strange sounding question… T/G

I remember this was posted a month or two ago and we had some serious debate on this prepayment burnout. I think the final answer that Schweser gave was 2011 or something, saying that everybody would’ve repayed in the first year (2010) and that not many would be left to take advantage in the next year. We thought it was a pretty shite question, and I was thinking at least not until 2012 when everybody “caught on.” I think we came to the concensus that it was another BS question.

Guess it was not just me…I thought it was a BS question as well. Your answer: D was incorrect. The correct answer was B) 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.

Sorry, was a bit off in the years from what I rememberd. But yeah, we thought definitely it should’ve been 2013. I still don’t see why it should be 2012?

Exactly. If interest rates continue to decrease or stay the same then there will be less prepayments in 2013 than 2012. Also if interest rates increase in 2013 then there will be less prepayments than in 2012. So any way you look at it, there would be less prepayments in 2013 than in 2012 right?

Yeah, I’m in total agreement with you. This ambiguity should be removed from test day, but I can see them pulling some shite like this in different ways.

I guess one way to look at it since we don’t know what happens in 2013, hypothetically imagine rates are at 12% in 2010 11% in 2011… etc, then all the sudden in 2013 rates drop to 1%, the prepayment would then begin to increase again. This is not practical, but I guess the point of the question is you just can’t assume…

a. the othere years, people will experience burnout.

I meant B.