Prepayment Risk Research Articles

Prepayment Analysis of Residential Mortgage Backed Securities for Indian Securitization Market

Residential Mortgage Backed Securities are gaining momentum in India, as the same are likely to be listed and traded in public domain. This has prompted the analysis of different aspects of pricing its products. Various risk elements control the prices of these products and prepayment is one of the most critical of them. This paper attempts to identify and analyze two factors i.e seasonality and seasoning, contributing to the prepayment risk associated with the residential mortgage backed securities in Indian market where the underlying asset is based on retail housing loans to the individuals in India. The data collected pertained to existing pools securitized in recent past. Unlike the pattern observed in the developed economies, this study indicates that the prepayment does not significantly change in different months or seasons of a year. However, the ageing of pools (seasoning) has significant impact on prepayments, which is in consonance with the developed economies. The prepayments have shown a declining trend with age.

Participating Mortgages and the Efficiency of Financial Intermediation

This paper distinguishes Participating Mortgages (PMs) from Convertible Mortgages. We study variants of PMs to demonstrate that they have the potential of improving the efficiency of a financial system. We resort to closed-form formulae to price profit caps and floors identified in variants of PMs. Our contribution includes finite maturity pricing formulae, which are scarce in real estate finance as most contracts are of definite tenure. We also focus on random tenure mortgages, which occur in the context of default and pre-payment risk. Finally, we conclude our study with a public policy implication of employing PMs as workout loans especially in the ongoing sub-prime crisis.

International Real Estate Review

This study is structured around two objectives: surveying the 180 years’ evolution of the US mortgage intermediation system (MIS); and, extracting the lessons to be learned by emerging mortgage markets. To that end, I first discuss three pillars of a well-functioning MIS as a conceptual underpinning - intermediation efficiency, affordability enhancement, and risk management. The historical survey proceeds based on four reasonably distinct time periods – (1) the era of exploration (pre-1930s or pre-Great Depression era), (2) the era of institutionalization (1930s to 1960s), (3) the era of market-making (1970s and 1980s), and (4) the era of expansion and efficiency gain (1990s to Present). Based on the survey done, the lessons for other countries are organized under five topics: developing conforming mortgage product and market; extending the service to nonconforming segments; managing default and prepayment risks; managing systemic risk; and, developing an efficient intermediation process. The concluding remarks in the final section comprise the issue of right sequencing: that is, through what steps an MIS in a given country can be evolved toward a more market-based one that can deliver a higher degree of consumer welfare.

International Real Estate Review

We combine loan data from distinct sources to compare and contrast multifamily mortgage lending in Canada and the U.S. After a general comparison of the multifamily housing markets in the two countries, we focus on loan pricing and non-price contract terms in the two environments. We find longer loan terms in the U.S. compared to Canada and attribute this to the greater liquidity available from a more established secondary mortgage market. We also find that while nominal rates are higher in Canada, mortgage spreads are actually lower, a result likely due to contract features that raise the cost of default for borrowers and restrict prepayments". In terms of loan performance, we found greater prepayment risk in U.S. mortgages and greater default risk in Canadian mortgages, although findings regarding default are limited by small sample size.

Limits of Arbitrage: Theory and Evidence from the Mortgage‐Backed Securities Market

ABSTRACT“Limits of Arbitrage” theories hypothesize that the marginal investor in a particular asset market is a specialized arbitrageur rather than a diversified representative investor. We examine the mortgage‐backed securities (MBS) market in this light. We show that the risk of homeowner prepayment, which is a wash in the aggregate, is priced in the MBS market. The covariance of prepayment risk with aggregate wealth implies the wrong sign to match the observed prices of prepayment risk. The price of risk is better explained by a kernel based on MBS market‐wide specific risk, consistent with the specialized arbitrageur hypothesis.

Does Prepayment Risk of Mortgages Affect Excess Returns of Bank Stocks?

This paper explores the relationship between the prepayment risk embedded in conventional, fixed-rate residential mortgages and excess returns for bank stocks. There are two interesting findings in this study. First, commercial banks traded in the Nasdaq market are more meanvariance efficient than the other seven groups of industrial stocks. Second, the prepayment risk factor is significant for these banks. The prepayment risk mainly reflects a call option embedded in a mortgage plus foreclosure costs associated with a mortgage put option. This risk is measured by a remaining part of mortgage rates after excluding the influence of real estate market, maturity, and default risks on mortgage rates. The results of this study suggest that the prepayment risk factor does significantly affect excess returns for bank stocks in the period with high levels of mortgage refinancing activities.

Structural prepayment risk behavior of the underlying mortgages for residential mortgage life insurance in a developing market

Since 1998 all residential mortgages in China have been adjustable rate mortgages (ARMs). However, the borrower’s motivation for prepayment is different from that in the US or other developed mortgage markets. In the US, mortgage insurance plays an imperative role in covering some of the risk typically faced by housing finance institutions. However, China’s residential mortgage life insurance (RMLI) market is in its infancy. It offers the insured mortgagor a life-insurance death benefit, arising from only illness or accident, settling the insured’s outstanding residential mortgage balance. Prepayments of some RMLIs’ underlying mortgages are observed, leading to a premature termination of both the residential mortgage and the insurance commitment to settle the outstanding mortgage balance even though the insured has not yet passed away. Because such prepayments significantly influence the pricing of the RMLI, it is imperative to know more about the prepayment rate of occurrence and the prepayment characteristics of the underlying residential mortgages in terms of observable macro economic factors, loan specific factors and borrower specific characteristics. Hence, this study investigates the prepayment risk behavior of the underlying mortgages for RMLIs, utilizing a pilot study of 1000 Shanghai residential mortgagors who took up RMLIs between January 1999 and December 2003. This study uses the Cox proportional hazard model to investigate RMLI-mortgage prepayment risk behavior. The resultant hazard rate is dependent on four primary factors: combined monthly income of the co-borrowers, growth in the gross domestic product, number of co-borrowers and initial loan-to-value ratio.

Securitization of Senior Life Settlements

Securitization has been an extremely important technique for managing exposure to a variety of financial risks. It allows the undesired risk to be concentrated in a small proportion of the newly created securities while largely eliminating its impact for most investors. Securitization had its very successful debut with mortgages, as a way to tap into funding from the bond market with mortgage-backed securities that were largely insulated from the inherent exposure of the underlying mortgages to prepayment risk. Since then, it has been extended to a wide range of securities and categories of risk. In this issue9s Innovations section, Stone and Zissu describe a new kind of securitization, in which the risk to be managed is the risk of death. Or the opposite, actually: It is “longevity risk,” the risk that an insured person will live too long, i.e., longer than their actuarial expected life span. A senior life settlement contract provides a way for a terminally ill, or very old, holder of a life insurance policy to liquidate it and obtain cash prior to death. The article describes how a portfolio of life settlement contracts may be securitized and tranched, and discusses pricing and risk management for the new securities. <b>TOPICS:</b>Risk management, MBS and residential mortgage loans

キャッシュリザーブを用いたモーゲージ担保証券優先劣後構造の最適設計

Owing to the agentification of the Government Housing Loan Corporation, Japanese private financial institutions are now developing long-term fixed-rate loans. In order to reduce the risk of yielding mismatches between asset and liability, financial institutions will sell out their loans by securitization instead of holding loans themselves. Mortgage backed security (MBS) is a product of mortgage securitization, which is issued backed by the repayment cash flow from a loan pool consisting of many mortgage loans. In mortgage loans, borrowers are basically allowed to make prepayment. Repayment cash flow from a loan pool changes due to the prepayment. So there is a prepayment risk in MBS, which means that investors cannot invest excessive liquidity in a planned yield or duration when prepayment occurs faster than forecast. Collateralized Mortgage Obligation (CMO) is a form of MBS, in which repayment cash flow from a loan pool is reorganized and bonds with various risks are issued. In this paper, we propose a method of designing CMO with PAC-Companion structure. We divide repayment cash flow, which is unstable due to uncertainty of prepayment, into two parts; a part in which principal repayment schedule must be satisfied (planned amortization class, PAC) and an unstable high-prepayment risk part (companion). We allow the repaid cash to be reserved in order to repay PAC bondholders in the following periods, which will make it possible to issue more PAC bond. We formulate the problem of determining an optimal PAC-companion structure as a mathematical programming problem and use a simulation-based approach to approximate the problem. We show that our model can be reformulated as an equivalent linear programming problem. Furthermore, we propose a modified model which yields a higher performance than the basic model. Finally we conduct numerical experiments and report the results.

An options-based approach to evaluating the risk of Fannie Mae and Freddie Mac

Fannie Mae and Freddie Mac assume a significant amount of interest and prepayment risk and all of the credit risk for about half of the $8 trillion U.S. residential mortgage market. Their hybrid government–private status, and the perception that they are too big to fail, make them a potentially large, but largely unaccounted for, risk to the federal government. Measuring the size and risk of this liability is technically difficult, but important for the debate over the appropriate regulation of these institutions. Here we take an options pricing approach to evaluating these costs and risks. Under the base case assumptions, the estimated value of the guarantees is $7.9 billion over 10 years, with a combined .5 percent value at risk of $122 billion. We evaluate the sensitivity of these estimates to various modeling assumptions, and also to the regulatory regime, including forbearance policies and capital requirements. The analysis highlights the benefits, but also the challenges, of taking an options-based approach to evaluating the value of federal credit guarantees.

An analysis of variable rate residential mortgage prepayment in Hong Kong using aggregate data

A distinctive feature of mortgages as assets is the existence of prepayment risk, typically viewed as a borrower’s call option to pay the outstanding mortgage balance at any time during the term. While previous research identified important causes for prepayment, these studies are mostly based on fixed‐rate mortgages, with little work on variable‐rate or floating‐rate mortgages and even less work on prepayment in countries other than the USA. This paper presents an analysis of prepayment based on the historical aggregate pre‐payment experience of a sample of variable rate mortgages in Hong Kong, which func‐tions under a Currency Board Mechanism that determines exogenously the level and term structure of interest rates. With variable rate mortgages, it is expected that there will not be a prepayment incentive with decreases in interest rates, unlike the case with fixed‐rate mortgages. However, we argue that observed interest rate movements remain a key factor that affects prepayment decisions, because current interest changes influence expected future interest rates. Furthermore, drawing on quasi‐rational and behavioral economics concepts, we expect the effect on prepayment of expected upward movement in interest rates to be stronger than that of expected downward movements. Empirical evidence from the adjustable rate residential mortgage sample from Hong Kong supports these expected relationships.

Subsidies in a Context of Efficient Markets: A New Framework for Evaluating the Role of Fannie Mae

Fannie Mae and Freddie Mac have been the focus of extensive Congressional, academic, and journalistic scrutiny in recent years. Much of this attention has been due to a claim that their shareholders and employees benefit inordinately from the companies' Congressional charter and that this charter permits unlimited portfolio growth. The impact of their status has been labeled an implicit in several controversial studies. The theoretical underpinning of the implicit observation is an application of the standard microeconomic model of subsidies for producers of tangible goods. The standard goods model concludes that the subsidized producer will capture all or most of the subsidy and will expand without limit until it becomes a monopolist. The goods model cannot be applied to financial assets. Because financial markets are efficient, Fannie Mae is unable to benefit through its retained portfolio from any lowering of debt yields because mortgage backed security (MBS) yields will be lowered by at least the same amount. Selling agency debt to buy agency MBS is accomplished at prices set in a broad and competitive market. The spread between these two securities reflects the prepayment risk in mortgages and liquidity differences between MBS and debt. For Fannie Mae's portfolio to earn above-normal returns, the spread between MBS and debt would have to be in some way too large. Because many investors are able to trade in these securities to capture any deviations from a market rate of return given the inherent risk, all abnormal returns are traded away. In fact, the sale of agency debt to finance MBS redistributes risks to those investors best able to manage them and thus lowers risk premiums, causing MBS yields to fall at least as much as debt yields. We note that the agency debt and mortgage-backed securities markets are predicated on the Congressional charter. That charter provides access to the market, opens up classes of investors to agency securities, provides stability to investors and lowers the yields of both agency debt and of MBS, thus fostering the 30-year mortgage.

Prepayment Risk-and Option-Adjusted Valuation of MBS

This exploration of risk-neutrality in MBS prepayments introduces option-adjusted valuation of MBS with consideration of prepayment risk, i.e., the risk that future prepay speeds systematically drift away from a model. A new measure, prepayment risk- and option-adjusted spread (prOAS), is suggested to replace the traditional option-adjusted spread, which varies widely across instruments. PrOAS levels the playing field by assuming that all liquid MBS and their derivatives are traded flat to the same debenture curve, on a risk- and option-adjusted basis. There are two alternative and theoretically equivalent methods of pricing with prOAS: 1) solving pricing PDEs with risk terms explicitly for pass-throughs using the active-passive decomposed prepay model, and 2) using a risk-neutral prepayment model, which is more universal. Although the prOAS method generally works well in case studies, there are some exaggerated dynamics of prices of risk and market dislocation in times of panic that offer arbitrage opportunities.

The ABCs of HELs

The home equity loan (HEL) sector has grown exponentially since 2002, to form the largest component of the asset-backed securities market. Their high liquidity and attractive spread pickup over the benchmark auto and credit card sectors increasingly make them a core holding for ABS investors. HEL bonds demand careful analysis because of an inherent mix of credit, prepayment, and structural risks. This overview of the HEL market evolution over the past decade provides some perspective on the risks and opportunities in the sector. It examines typical loan characteristics, underwriting trends, and the drivers of collateral performance, and discusses typical structural features of HEL ABS transactions and the key risk factors for ABS bondholders.

Analyses of Mortgage-Backed Securities Based on Unobservable Prepayment Cost Processes

We propose a prepayment model of mortgage based on a structural approach in order to analyze prepayment risk of mortgage-backed securities (MBS). We introduce a continuous process named prepayment cost process. Specifically, each mortgager's prepayment time is defined by the first time when her or his prepayment cost process falls below zero, but prepayment cost processes are supposed to be unobservable in the market. We also introduce a risk unique to each loan pool of mortgages, called a loan pool risk (LPR), and we regard LPR as a systematic risk other than interest rate. Using the model, we discuss the conditional distribution of prepayment times and a risk-neutral valuation of pass-through MBS. It is shown that each mortgager's conditional non-prepayment probability and the posterior distribution of LPR play quite important roles in our study.

The impact of loan prepayment risk and deposit withdrawal risk on the optimal intermediation margin

Numerous studies have analyzed how a bank's intermediation margin varies with respect to such factors as credit quality, funding risk, bank capital, deposit insurance and other factors. However, these studies ignore the potential that loans tend to prepay if interest rates decline and deposits tend to be withdrawn if interest rates rise. Taking this very fundamental fact into account, we derive optimal loan rates and deposit rates when the bank is subject to loan prepayments and deposit withdrawals. Among other things, we find that greater volatility of interest rates tends to increase the margin. The strength of the correlation between the level of interest rates and the propensity to prepay loans (withdraw deposits) also plays an interesting role.

Does Mortgage Hedging Amplify Movements in Long-Term Interest Rates?

The growth of the mortgage market in recent years raises the question of what effects, if any, the hedging of mortgage portfolios has on the behavior of long-term interest rates. The evidence here is that the ten-year swap rate implied by swaptions becomes more volatile when the prepayment risk of outstanding mortgages increases—most likely because investors expect the hedging of prepayment risk to amplify future interest rate movements. These amplification effects can be considerable, but they are generally expected to persist for only several months.

Does Mortgage Hedging Amplify Movements in Long-term Interest Rates?

The growth of the mortgage market in recent years has raised the question of what effects, if any, the hedging of mortgage portfolios has on the behavior of long-term interest rates. This paper finds that the volatility of the ten-year swap rate implied by swaptions increases when the prepayment risk of outstanding mortgages increases--most likely because investors expect the hedging of prepayment risk to amplify future interest rate movements. These amplification effects can be considerable in magnitude, but they are generally expected to persist only for several months.

International Real Estate Review

The prepayment risk of adjustable rate mortgages, unlike that of fixed rate mortgages, greatly depends on the decision of mortgagors to move. Given that housing also serves as an investment asset for the owner, it is hypothesised that the expected capital returns of housing are likely to affect his decision to move and hence, prepay. This paper aims to test the capital gains hypothesis using Singapore’s housing market as a case study. In addition, this paper also explores how the expected returns from alternative types of housing affect the decision of households to move/prepay. The expected returns of housing are computed in accordance with the definitions of the Rational Expectation Hypothesis, Adaptive Expectation Hypothesis, and Exogenous Expectation Hypothesis, which are well established in macroeconomic literature and the explanation of cycles. The results showed that the expected returns of public housing formed under the assumptions of rational and adaptive expectation hypothesis are significant. The rational expected return for private housing, however, does not have a significant relationship with the decision of mortgagors to move/prepay, although the adapted expected return for private housing is not significantly related to the households' length of stay.

Prepayment Modeling and Valuation of Dutch Mortgages

The Dutch mortgage-backed securities (MBS) market is the benchmark euro-denominated MBS market. It is also one of the few European markets where mortgage coupons are fixed for extended periods of time, so prepayment risk is an important factor. A general prepayment modeling framework is used to develop a model for Dutch MBS, using historical speeds on Dutch mortgage deals. A key issue for the refinancing component is reconciliation of the fast speeds observed in periods of low rates, such as in 1999, with the presence of severe prepayment penalties, which in theory should discourage refinancings. An innovative approach models the refinancing incentive not just in terms of the current level of rates, but also taking into account the relationship of rates to the past. An option-adjusted spread analysis of the fixed-rate A2 class of the Match 2002–1 MBS deal provides an illustration.