Prepayment Risk

[Dar_Shan0209]

Hi tutors,

I am working on September 2012Q4(ii). My understanding is that mortgage-backed security is made up of a bundle of home loans that investors can purchase. Investors in mortgage-backed securities collect interest payments made by the underlying home loans. As such, when the homeowners repay their loans earlier than expected, investors in mortgage-backed securities face the risk of having lower future interest payments generated from the underlying home loans. The so called prepayment risk. What do you think can be mitigating actions/tools for this:

(i)under this scenario;
(ii)under a general market risk point of view?

I am thinking of only penalties that could be imposed for early repayment but I don't know if this is feasible or common market practice because that would not be TCF.

Thanks to advise.

 

[Anna Bishop]

Hi Darshan

I feel like I've learned something new today as well so thanks for the query! I hadn't realised that some mortgage backed securities work on this 'pass through' basis, where the investor in the MBS is effectively receiving the mortgage payments from the underlying mortgages. In that case, the pre-payment risk flows directly through to the investor in the MBS. If the mortgages are repaid early, then the risk is that the investor in the MBS has to reinvest the proceeds on potentially unknown future yields ... which may be less than the current yield on the MBS. Interesting!

I'd always assumed previously that the MBS work like a collateralised debt obligation, where the investor in the MBS buys fixed interest bonds (often there are different tranches of bond) ... where the bonds are secured on the underlying mortgages. Therefore, the prepayment risk falls in the first instance to the issuer of the bonds ... as presumably the issuer would then have less revenue than expected with which to make the coupon payments on the bonds. I'm thinking this could, in turn, lead through to increased default risk to the investor in the MBS.

Having read up this morning, it seems that both these approaches exist: https://www.investopedia.com/terms/m/mbs.asp

Looking back to the wording of Sep 2012 Q4, I am reading this second interpretation as it talks about pre-payment risk to ABC in the solution. What do you think?

Anyway, to answer your question ... how to mitigate pre-payment risk? If we are considering the 'pass through' approach, the risk falls largely with the investor. I would probably mention the usual candidates - diversification in different securities / geographical regions, only investing if the yield seems commensurate with the risks (including prepayment risk). Additionally, I started thinking about the triggers for pre-payment, eg interest rate falls causing mortgage holders to renegotiate their mortgage, or a reduction in the credit-worthiness of mortgage holders causing homes to be sold. The investor in the MBS could consider mitigating these (more indirect) risks, eg via, a 'floor' to hedge against falls in interest rates beyond a certain point, or some sort of CDS.

If we are considering the second interpretation, eg as per ABC Mortgages in the past exam question, then I think your idea of early payment penalties is definitely worth mentioning. Also again ways of hedging against the risk of interest rates falling ... and underwriting / scoring / due diligence on the potential mortgage holders to ensure good credit worthiness.

Early payment penalties are pretty common in the UK. We have one on our mortgage!

OK, I'll stop rambling, hope this is useful
Anna

 

[Dar_Shan0209]

Hi Anna,
Thank you so much with this detailed way of thinking. My mind is sore thinking of both scenarios and when thinking how it works. But it is definitely helpful and it answers my question. Didn't know that early payment penalties is common market practice, but happy to note other mitigating tools as well.

Thanks again.