Amortized prepayment speed

What Is Amortized Prepayment Speed?

Amortized prepayment speed refers to the rate at which the principal of a mortgage or a pool of mortgages is paid down earlier than its scheduled amortization, impacting the expected cash flow of related investments, particularly within fixed income and securitization. In investments like a mortgage-backed security (MBS), the underlying mortgages are expected to amortize over a set period. However, borrowers can prepay their loans through actions like refinancing, selling the property, or making additional principal payments. The amortized prepayment speed quantifies how quickly this unscheduled principal return occurs, which is a critical factor for investors in assessing potential returns and prepayment risk.

History and Origin

The concept of prepayment speed became central with the rise of the mortgage-backed securities market. Before the 1930s, U.S. housing finance often involved short-term loans with large balloon payments. The Great Depression led to widespread defaults and foreclosures, prompting federal intervention. The Federal Housing Administration (FHA) was created in 1934 to insure mortgages, and the Federal National Mortgage Association (Fannie Mae) was chartered in 1938 to provide liquidity by buying FHA-insured loans¹¹.

A pivotal moment occurred in 1968, when the Housing and Urban Development Act split Fannie Mae into two entities, with the Government National Mortgage Association (Ginnie Mae) emerging as a government-owned corporation within the Department of Housing and Urban Development (HUD)¹⁰. In 1970, Ginnie Mae developed and guaranteed the first mortgage-backed security, allowing pooled loans to be sold in the secondary market⁹. This innovation, followed by similar issuances from Freddie Mac and Fannie Mae, created a robust market for MBS. As these securities became more complex and widely traded, the unpredictable nature of borrower prepayments became a significant concern for investors. The need to quantify this behavior led to the development of sophisticated prepayment models, which estimate amortized prepayment speed, to better understand the future cash flows of MBS.

Key Takeaways

• Amortized prepayment speed measures the rate at which mortgage principal is returned to investors earlier than scheduled.
• It is a crucial factor for valuing mortgage-backed securities (MBS) and managing associated risks.
• Factors like prevailing interest rate risk, borrower characteristics, and economic conditions significantly influence amortized prepayment speed.
• Higher prepayment speeds can lead to reinvestment risk for MBS investors, as returned principal may need to be reinvested at lower prevailing yields.
• Sophisticated models are used by market participants to forecast this speed, though challenges persist, especially during uncertain economic periods.

Formula and Calculation

Amortized prepayment speed is not a direct formula that yields a single number like a standard financial ratio. Instead, it is typically expressed through a prepayment model, such as the Public Securities Association (PSA) Prepayment Model, or as a percentage of the outstanding mortgage pool balance that prepays in a given period.

The PSA model, for instance, assumes a monthly prepayment rate that starts low and increases over the first 30 months of a mortgage's life before leveling off. A "100% PSA" speed implies a 0.2% Constant Prepayment Rate (CPR) in the first month, increasing by 0.2% each month until it reaches 6% CPR in month 30, after which it remains at 6% CPR for the remainder of the mortgage's life.

The CPR itself can be calculated monthly and annualized:

[
\text{CPR} = 1 - (1 - \text{MDR})^{12}
]

Where:

• MDR = Monthly Prepayment Rate

The monthly prepayment rate (MDR) is the percentage of the remaining mortgage principal that is prepaid in a given month. For a pool of mortgages, this would be:

[
\text{MDR} = \frac{\text{Prepayments for the Month}}{\text{Beginning Mortgage Balance for the Month} - \text{Scheduled Principal Payments for the Month}}
]

Investors use these rates to project future cash flow streams from an MBS, factoring in both scheduled principal and interest payments, and the estimated amortized prepayment speed.

Interpreting the Amortized Prepayment Speed

Interpreting amortized prepayment speed is essential for investors in mortgage-backed securities because it directly impacts the timing and amount of their expected cash flows. A higher amortized prepayment speed means investors receive their principal back sooner than expected. While this might seem beneficial, it often occurs when interest rates decline, prompting borrowers to refinancing their mortgages at lower rates. This creates reinvestment risk, as the investor must then reinvest the returned principal at the lower prevailing yield. Conversely, a lower amortized prepayment speed, typically seen when interest rates rise, means borrowers are less likely to refinance. This can extend the effective duration of the MBS, potentially making it less attractive if alternative investments offer higher yields.

Analysts use models to project amortized prepayment speed based on various factors, including the loan's coupon rate relative to current market rates, borrower credit scores, loan-to-value ratios, and broader housing market conditions⁸. The deviation of actual prepayment speeds from these projections can significantly affect the option-adjusted spread of an MBS, which is a key measure of its value.

Hypothetical Example

Consider an investor holding a mortgage-backed security backed by a pool of 1,000 fixed-rate mortgage loans, each with an original balance of $200,000 and a 4% interest rate, totaling $200 million in principal.

In a given month, after scheduled principal payments are made, the remaining balance of the pool is $198 million. Due to a significant drop in market interest rates, 50 of the underlying borrowers decide to refinance their homes, paying off their entire $180,000 remaining balances. Additionally, 10 other borrowers sell their homes and prepay their $190,000 remaining balances.

Total unscheduled prepayments for the month:
(50 mortgages * $180,000) + (10 mortgages * $190,000) = $9,000,000 + $1,900,000 = $10,900,000.

Let's assume the scheduled principal payments for the month were $1,000,000.
The beginning mortgage balance for the month was $200,000,000.

The monthly prepayment rate (MDR) for this period would be:

To annualize this to a Constant Prepayment Rate (CPR), assuming monthly compounding:

This indicates a very high amortized prepayment speed, significantly impacting the investor's expected cash flows. The investor would receive approximately 49.47% of the remaining principal balance (on an annualized basis) earlier than anticipated, forcing them to reinvest these funds potentially at lower current market rates.

Practical Applications

Amortized prepayment speed is a critical metric across various facets of financial markets:

• Mortgage-Backed Securities (MBS) Valuation: For investors in MBS, accurate forecasting of amortized prepayment speed is paramount. It dictates the actual cash flow received from these securities, influencing their pricing and yield calculations. If prepayments are faster than expected, the investor receives principal back sooner, potentially at a time when interest rates are lower, leading to reinvestment risk. Conversely, slower prepayments extend the bond's duration.
• Risk Management: Financial institutions holding large portfolios of mortgages or MBS use amortized prepayment speed projections to manage their interest rate risk and liquidity risk. Unexpected shifts in prepayment speeds can lead to mismatches in asset and liability durations.
• Monetary Policy Analysis: Central banks, such as the Federal Reserve, consider amortized prepayment speeds when implementing monetary policy, particularly during large-scale asset purchase programs involving MBS. The Fed's purchases of agency MBS, for instance, are intended to lower long-term interest rates and support housing markets⁷. The effectiveness of these programs can be influenced by how quickly mortgages are prepaid.
• Underwriting and Loan Origination: Lenders analyze historical prepayment patterns to refine their mortgage underwriting standards and pricing. Understanding which loan characteristics and borrower behaviors are associated with certain prepayment speeds helps them assess the profitability and risk of new originations.
• Regulatory Oversight: Regulatory bodies like the U.S. Securities and Exchange Commission (SEC) have implemented disclosure requirements for residential MBS (RMBS) to provide greater transparency to investors. These regulations mandate detailed, asset-level data on the underlying mortgages to help investors evaluate default risk and prepayment behavior more effectively⁶.

Limitations and Criticisms

While essential for valuing interest-rate sensitive securities, models that estimate amortized prepayment speed have inherent limitations and face ongoing criticisms. One major challenge is the complexity and variability of borrower behavior. Prepayments are influenced by a multitude of factors beyond just interest rates, including individual economic incentives, life events (job loss, relocation), and even behavioral biases, making them difficult to predict accurately⁵. For example, during periods of extreme market uncertainty or significant government intervention, historical prepayment patterns may not hold true, leading to model inaccuracies⁴.

Another criticism is the reliance on historical data, which may not adequately capture future "regime shifts" in the economy or housing market conditions. Models calibrated on past performance can struggle to predict behavior in unprecedented environments, as was evident during the 2008 financial crisis and the subsequent COVID-19 pandemic³. The sheer volume and heterogeneity of loans within a mortgage pool also contribute to complexity, making it challenging to develop a single model that precisely captures the unique characteristics and behaviors of all borrowers².

Furthermore, data availability and quality can pose limitations, especially for older or less transparent mortgage pools. While new SEC regulations aim to standardize asset-level disclosures for residential mortgage-backed securities (RMBS), the volume of publicly registered RMBS offerings has been limited, making it harder for investors to obtain comprehensive data for analysis compared to agency MBS¹. These limitations mean that models, while sophisticated, always carry a degree of model risk and require continuous refinement and expert judgment to interpret results, particularly during volatile market periods.

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

Amortized prepayment speed is a measure or outcome of how quickly mortgage principal is paid off, while the Public Securities Association (PSA) Prepayment Model is a standardized benchmark or convention used to project this speed.

In essence, amortized prepayment speed is the phenomenon being observed and modeled, while the PSA Prepayment Model is one of the common tools or frameworks used to describe or project that phenomenon. When an investor refers to an MBS prepaying at a certain "PSA speed," they are using the PSA model as a reference point to describe the expected or actual amortized prepayment speed of that security.

FAQs

What causes amortized prepayment speed to change?

Amortized prepayment speed is primarily influenced by changes in interest rates. When current market interest rates fall significantly below a borrower's mortgage rate, there's a strong economic incentives to refinance, leading to higher prepayment speeds. Other factors include property sales, borrower credit quality improvements allowing for better loan terms, and specific loan characteristics like the presence of prepayment penalties. Economic conditions, such as employment rates and housing market trends, also play a role.

How does amortized prepayment speed affect MBS investors?

For investors in a mortgage-backed security, amortized prepayment speed directly impacts the timing of their cash flow. If prepayments are faster than expected, investors receive their principal back sooner. This exposes them to reinvestment risk if interest rates have fallen, forcing them to reinvest at lower yields. Conversely, slower prepayments mean the investment extends longer than anticipated, which can be detrimental if interest rates have risen.

Is a high amortized prepayment speed always bad for investors?

Not necessarily. While a high amortized prepayment speed often implies reinvestment risk in a declining interest rate environment, it also means the investor receives their principal back sooner. The impact depends on the investor's specific objectives, their ability to find new investments, and the prevailing market conditions. For instance, if an investor had accounted for a higher prepayment speed in their initial yield calculations, the actual outcome might align with expectations.

How do analysts predict amortized prepayment speed?

Analysts use sophisticated prepayment models that consider a wide range of factors. These models often incorporate historical data on borrower behavior, current interest rate differentials (the spread between the mortgage coupon rate and current market rates), housing prices, loan-to-value ratios, and credit scores. Economic forecasts are also integrated to project future scenarios. The goal is to estimate the likelihood of refinancing or other prepayment events.