Active prepayment speed: Meaning, Criticisms & Real-World Uses

What Is Active Prepayment Speed?

Active prepayment speed refers to the actual, observed rate at which borrowers prepay their outstanding debt obligations, particularly within pools of loans such as those backing mortgage-backed securities (MBS) and other Asset-Backed Securities (ABS). In the context of fixed-income securities, understanding active prepayment speed is crucial for investors and analysts in the field of securitization, as it directly impacts the cash flow and yield of these investments. When borrowers pay off their loans earlier than anticipated, it constitutes a prepayment event, affecting the expected income stream for the security holders. This phenomenon introduces prepayment risk, a significant consideration in the valuation and risk management of such securities.

History and Origin

The concept of measuring and modeling prepayment behavior gained prominence with the growth of the mortgage-backed securities market. As financial institutions began pooling mortgages and selling shares of the resulting cash flows to investors, the unpredictable nature of borrower prepayments became a critical factor in determining the securities' true value. To standardize the analysis of prepayment behavior, the Public Securities Association (PSA), a predecessor to the Securities Industry and Financial Markets Association (SIFMA), developed its widely recognized PSA prepayment model in 1985. This model provided a benchmark for comparing actual prepayment rates. Early academic work, such as "Complete Prepayment Models for Mortgage-Backed Securities" published in Management Science, sought to define the key factors influencing prepayment rates, including refinancing incentives, seasonal variations, mortgage pool seasoning, and burnout effects, building a foundation for understanding active prepayment speed.⁵, ⁶

Key Takeaways

Active prepayment speed is the observed rate at which borrowers pay off their loans ahead of schedule.
It is particularly important for Mortgage-Backed Securities (MBS) and other securitized products.
Prepayments impact the expected cash flow and duration of these securities.
Factors such as interest rate movements, housing market conditions, and borrower demographics significantly influence active prepayment speed.
Unexpected changes in active prepayment speed can lead to reinvestment risk or extension risk for investors.

Formula and Calculation

Active prepayment speed is typically measured using metrics that reflect the rate of principal reduction. Two common measures are the Single Monthly Mortality (SMM) rate and the Conditional Prepayment Rate (CPR).

The Single Monthly Mortality (SMM) rate calculates the percentage of the outstanding principal balance of a mortgage pool that was prepaid in a given month.

\text{SMM} = \frac{\text{Principal Prepaid in Month}}{\text{Beginning Principal Balance for Month} - \text{Scheduled Principal Payment for Month}}

The Conditional Prepayment Rate (CPR) annualizes the SMM rate to provide an annual estimate of prepayments.

\text{CPR} = 1 - (1 - \text{SMM})^{12}

These formulas provide a way to quantify the active prepayment speed of a loan pool. Financial models, such as the PSA model, then project expected prepayment speeds against which the actual SMM or CPR can be compared. For instance, 100% PSA assumes an increasing prepayment rate for the first 30 months, peaking at an annualized rate of 6%, and then remaining constant thereafter.

Interpreting the Active Prepayment Speed

Interpreting active prepayment speed involves comparing the observed rate to expected rates and understanding the implications for the investment. A higher-than-expected active prepayment speed, often triggered by widespread refinancing activity when interest rates fall, means investors receive their principal back sooner than anticipated. For securities purchased at a premium (above face value), this faster return can reduce the overall yield to maturity because less interest income is collected. This scenario is known as contraction risk.

Conversely, a lower-than-expected active prepayment speed, which might occur when interest rates rise or lending standards tighten, means borrowers are paying off their loans more slowly. For securities purchased at a discount (below face value), slower prepayments can reduce the speed at which investors realize their capital gains, potentially extending the security's duration and exposing them to more interest rate risk. This is referred to as extension risk. Analysts constantly monitor active prepayment speed against benchmarks like the PSA model to assess the performance and risk of their portfolios.

Hypothetical Example

Consider a pool of new mortgages underlying an MBS with a total outstanding principal balance of $100 million.
In the first month, according to the standard PSA model (100% PSA), the expected annualized prepayment rate is 0.2%, or an SMM of approximately 0.0167%. If, however, the actual prepayments observed for that month total $200,000 (after accounting for scheduled principal payments), the active prepayment speed would be calculated.

Let's assume the scheduled principal payment for the month is $50,000.
Beginning Principal Balance = $100,000,000
Scheduled Principal Payment = $50,000
Principal Prepaid = $200,000

\text{SMM} = \frac{\$200,000}{\$100,000,000 - \$50,000} \approx 0.002001

\text{CPR} = 1 - (1 - 0.002001)^{12} \approx 0.0237 = 2.37\%

In this hypothetical example, an active prepayment speed of 2.37% CPR in month one is significantly higher than the 0.2% CPR expected by the 100% PSA model for the first month (which implies an SMM of 0.0167%). This higher-than-expected active prepayment speed would signal to investors that borrowers are paying down their principal more rapidly, potentially due to market conditions favoring early refinancing.

Practical Applications

Active prepayment speed is a critical metric for participants in the fixed-income markets, especially for those involved with mortgage-backed securities and Collateralized Mortgage Obligations (CMOs). Investment managers utilize active prepayment speed data to refine their prepayment models and forecasts, which in turn influences the pricing and selection of MBS. For example, if active prepayment speed is trending higher than anticipated due to declining interest rates, portfolio managers might adjust their holdings to mitigate reinvestment risk.

Regulators and policymakers, such as the Federal Reserve, also monitor active prepayment speeds to understand broader trends in the housing market and their impact on financial stability. Research from the Federal Reserve Bank of Boston, for instance, has examined how differences in mortgage prepayment behavior across racial groups can lead to disparities in interest rates paid by borrowers, highlighting a real-world consequence of varying active prepayment speeds.⁴ Furthermore, disclosure requirements set by bodies like the SEC mandate that issuers of securitized products provide detailed information about underlying assets, which helps investors assess potential prepayment behavior.³

Limitations and Criticisms

While active prepayment speed is a vital analytical tool, its interpretation and predictive power come with limitations. Prepayment models, including the widely used PSA model, are based on historical data and assumptions that may not perfectly capture future borrower behavior. Economic factors beyond interest rate movements, such as unemployment rates, housing price trends, and changes in lending standards, can significantly influence actual prepayment activity, leading to divergences from modeled expectations.¹, ² For example, during periods of economic distress, even if interest rates are low, borrowers may be unable to refinance due to declining home values or stricter credit risk criteria, leading to slower active prepayment speeds than rate-based models might predict.

Moreover, the "burnout effect" can complicate predictions; borrowers who have already had opportunities to refinance at lower rates may be less responsive to subsequent rate declines. This means that a seemingly attractive refinancing incentive might not result in the expected level of active prepayment speed if a significant portion of the eligible borrowers have already refinanced. The complexity of these interactions underscores that models provide estimates, and actual active prepayment speed can deviate due to unforeseen market dynamics or shifts in borrower financial conditions.

Active Prepayment Speed vs. Public Securities Association (PSA) Prepayment Model

Active prepayment speed refers to the actual, observed rate at which borrowers pay down their loans ahead of schedule. It is a measurement of what is currently happening in the market for a pool of loans. It reflects the real-world behavior of borrowers based on prevailing economic conditions, individual financial situations, and market incentives.

In contrast, the Public Securities Association (PSA) Prepayment Model is a standardized benchmark used to project expected prepayment rates for mortgage-backed securities over their lifetime. It provides a theoretical framework for how prepayments are assumed to behave. The PSA model establishes a baseline expectation, typically expressed as a percentage of "100% PSA," which outlines a gradual increase in prepayments during the initial months of a mortgage's life, followed by a constant rate. While active prepayment speed is a real-time observation, the PSA model is a hypothetical curve used for comparison, valuation, and scenario analysis of callable bonds like MBS.

FAQs

What causes active prepayment speed to change?

Active prepayment speed is influenced by several factors, including changes in prevailing interest rates (e.g., borrowers refinancing to lower rates), housing market conditions (e.g., home sales leading to mortgage payoffs), borrower demographics, and the age or "seasoning" of the loans in a pool. Economic downturns or tighter lending standards can also slow active prepayment speed.

How does active prepayment speed affect investors?

For investors in mortgage-backed securities, active prepayment speed directly impacts the expected cash flow and the average life of their investment. Faster speeds can lead to reinvestment risk (having to reinvest principal at lower rates), while slower speeds can lead to extension risk (the security's duration becoming longer than anticipated).

Is a high active prepayment speed always bad for investors?

Not necessarily. The impact of a high active prepayment speed depends on whether the investor purchased the security at a premium, par, or discount. If a security was bought at a discount, a higher active prepayment speed can be beneficial as it allows the investor to realize the discount more quickly, increasing the effective yield to maturity. However, for premium bonds, high prepayments are generally detrimental.