Explain mortgage-backed securities and the risk that borrowers prepay
The idea
A mortgage pass-through distributes the pool's interest and principal, including prepayments, to holders pro rata, less servicing fees. Prepayment is the distinctive risk: borrowers may repay early, and they do so disproportionately when rates fall and refinancing is attractive. That is contraction risk — principal returns exactly when it can only be reinvested at lower rates. When rates rise, prepayments slow and the security's life extends just as the investor would prefer to reinvest, which is extension risk. The homeowner holds a free option and exercises it against the investor in both directions.
A practice question
What is contraction risk in a mortgage-backed security?
- The risk that borrowers default on the underlying mortgagesWhy not: That is credit risk, and in an agency pool it is largely borne elsewhere. Contraction is about timing rather than loss.
- The risk that prepayments accelerate — correct
- The risk that the servicer failsWhy not: An operational risk, real but distinct. Contraction concerns how fast principal comes back.
Rates fall, principal comes back early, and it can only be redeployed at the new lower rates. Falling rates make refinancing attractive, which is what shortens the security.
A harder one
What happens to a pass-through security when interest rates rise?
- Prepayments accelerate and the security shortensWhy not: That is what happens when rates *fall* and refinancing becomes attractive. Rising rates give borrowers every reason to stay put.
- The coupon resets upwardWhy not: A pass-through's coupon derives from the underlying fixed-rate mortgages and does not reset.
- Prepayments slow and the security's expected life extends — correct
Refinancing becomes unattractive, so borrowers stay put. The investor is locked into a below-market coupon for longer, which is extension risk.
The hardest tier
Why is the homeowner's prepayment option described as costly to the investor in both directions?
- Because it shortens when rates are low and lengthens when high — correct
- Because it increases the credit risk of the poolWhy not: Prepayment is repayment in full — the best possible credit outcome. The cost is in the timing.
- Because prepayment penalties are paid to the servicerWhy not: Many mortgages carry no penalty at all, and where one exists it usually flows to the pool. The asymmetry exists without any penalty.
An option exercised optimally by one party is exercised adversely for the other. This asymmetry is why mortgage securities exhibit negative convexity and yield more than comparable government debt.
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