What Is Prepayment Speed?
Prepayment speed refers to the rate at which borrowers repay the principal on their loans earlier than originally scheduled. This concept is most commonly observed and analyzed within the Fixed Income market, particularly for debt instruments like Mortgage-Backed Security (MBS). A higher prepayment speed means that the underlying loans in a pooled security are being paid off more quickly, leading to faster-than-anticipated return of Principal to investors. Conversely, a lower prepayment speed indicates that repayments are occurring more slowly than expected. Understanding prepayment speed is crucial for investors as it directly impacts the Cash Flow and effective Yield of these securities.
History and Origin
The concept of prepayment speed became prominent with the growth of the Mortgage-Backed Security (MBS) market. MBS emerged in the United States as a way to convert illiquid mortgage loans into tradable securities, thereby expanding the availability of mortgage financing. The Government National Mortgage Association (Ginnie Mae) introduced the first mortgage pass-through security in 1968, followed by Freddie Mac in 1971 and Fannie Mae in 1981, marking the formal birth of the modern U.S. MBS market.14, 15 This Securitization process involved pooling thousands of individual mortgage loans and selling interests in the resulting cash flows to investors as Bond-like instruments.
However, unlike traditional bonds, the underlying mortgages could be paid off early due to factors like home sales or Refinancing when Interest Rates declined. This introduced "prepayment risk," making the timing of cash flows uncertain for MBS investors. Early models to predict these prepayments were developed in the 1980s by Wall Street firms to better understand and manage this risk, leading to the formalization of "prepayment speed" as a critical metric for valuing these complex securities.13
Key Takeaways
- Prepayment speed measures the rate at which borrowers pay off their loans ahead of schedule, primarily impacting mortgage-backed securities.
- It is heavily influenced by interest rate movements, with lower rates typically encouraging faster prepayments due to refinancing.
- Prepayment speed introduces uncertainty (prepayment risk) for investors in securities like MBS, affecting their actual yield and duration.
- Commonly expressed using metrics like Conditional Prepayment Rate (CPR) or Single Monthly Mortality (SMM).
- Accurately forecasting prepayment speed is essential for valuing MBS and managing associated portfolio risks.
Formula and Calculation
Prepayment speed is often expressed using standard metrics, most commonly the Conditional Prepayment Rate (CPR) or the Single Monthly Mortality (SMM). SMM is a monthly rate, while CPR is an annualized version of SMM.
The formula for Single Monthly Mortality (SMM) is:
Once SMM is calculated, it can be converted to an annualized CPR using the following formula:
These formulas provide a standardized way to quantify how quickly a pool of loans is prepaying its Amortization schedule.12
Interpreting the Prepayment Speed
Interpreting prepayment speed involves understanding its implications for fixed-income investments, particularly MBS. A high prepayment speed, often triggered by falling Interest Rates, means that borrowers are Refinancing their mortgages at lower rates or selling their homes. For MBS investors holding bonds with higher coupons (interest rates), this can be undesirable. The faster return of Principal means they must reinvest this capital at potentially lower prevailing market rates, leading to a reduced overall Yield. This scenario is known as "contraction risk," as the effective duration of the security shortens.11
Conversely, a low prepayment speed, often seen in rising interest rate environments, means borrowers are less likely to refinance, and existing loans stay on the books longer. For investors, this can lead to "extension risk," where the effective Duration of their security lengthens beyond initial expectations. Both extremes can impact a portfolio's returns and risk profile, necessitating careful monitoring and modeling of prepayment behavior.
Hypothetical Example
Consider an investor who owns a Mortgage-Backed Security (MBS) with an initial pool of mortgages valued at $100 million. In January, the scheduled principal payments for the month are $500,000. However, due to a sudden drop in interest rates, many homeowners in the pool decide to Refinancing their mortgages, resulting in actual prepayments of $1,500,000 for the month.
To calculate the Single Monthly Mortality (SMM) for January:
Beginning Loan Balance = $100,000,000
Scheduled Principal Payments = $500,000
Actual Prepayments = $1,500,000
First, determine the excess prepayments:
Excess Prepayments = Actual Prepayments - Scheduled Principal Payments = $1,500,000 - $500,000 = $1,000,000
Then, use the SMM formula:
Now, convert this SMM to an annualized Conditional Prepayment Rate (CPR):
This indicates that, if the January prepayment behavior were to continue for a full year, approximately 16.49% of the outstanding mortgage Principal in the pool would be prepaid annually. This high rate would mean the investor receives their principal back much faster than expected, potentially requiring reinvestment at lower rates.
Practical Applications
Prepayment speed is a critical input in the valuation and risk management of various Fixed Income securities, particularly those derived from pools of amortizing loans.
- Mortgage-Backed Securities (MBS) Valuation: Investors and analysts heavily rely on prepayment speed forecasts to project the expected Cash Flows from MBS. Since prepayments reduce the outstanding Principal balance, they directly affect the timing and amount of interest payments received by investors.10 Entities like Fannie Mae regularly publish data and analysis on prepayment speeds to aid market participants.9
- Collateralized Mortgage Obligation (CMO) Structuring: CMOs are complex derivatives of MBS, often segmented into different Tranches, each with a distinct claim on the underlying cash flows and varying sensitivities to prepayment risk. Prepayment models are essential for designing these tranches to meet different investor risk appetites.8
- Asset-Liability Management (ALM) for Lenders: Financial institutions that originate mortgages and hold them on their balance sheets must forecast prepayment speeds to manage their interest rate risk. Unexpected prepayments can create mismatches between their assets (loans) and liabilities (funding sources).
- Hedge Fund and Portfolio Management: Portfolio managers use prepayment forecasts to optimize their holdings, hedge against prepayment risk, and identify mispriced securities within the mortgage market. The U.S. Securities and Exchange Commission (SEC) also plays a role in regulating the disclosure requirements for Securitization products, including MBS, to ensure transparency for investors.6, 7
Limitations and Criticisms
While prepayment models are sophisticated, they face significant limitations and are subject to criticism due to the complex and often unpredictable nature of borrower behavior.
One primary criticism is that human behavior, which drives many prepayments (e.g., Refinancing, relocation, divorce, default), is not purely rational and cannot be perfectly modeled by mathematical equations. Factors such as a borrower's awareness of current Interest Rates, their willingness to go through a refinancing process, or idiosyncratic life events introduce an inherent stochastic element that is difficult to capture.4, 5
Furthermore, prepayment models, particularly those developed before major market dislocations, have historically struggled to predict speeds accurately during periods of extreme market stress, such as the 2008 financial crisis. The relationships between interest rates, housing prices, and borrower Credit Risk can shift in unexpected ways, leading to significant model error and impacting the performance of Mortgage-Backed Security (MBS) investments.3 Some researchers note that the forecasting effectiveness of proprietary models has been unreliable due to the non-linear and heteroskedastic nature of the prepayment function.2 The rapid changes in mortgage rates, for instance, in 2022, pushed MBS into "uncharted territory" with limited historical data for guidance, testing the limits of even advanced models.1
Prepayment Speed vs. Weighted Average Life (WAL)
While both prepayment speed and Weighted Average Life (WAL) are crucial metrics for understanding the timing of Cash Flows from debt instruments, especially Mortgage-Backed Security (MBS), they represent different aspects.
Prepayment speed is a rate that quantifies how quickly the underlying Principal of a loan pool is being paid down ahead of its scheduled Amortization. It's an input or a driver of changes in the security's maturity. A higher prepayment speed implies faster principal return.
Weighted Average Life (WAL), on the other hand, is a measurement of the average time until each dollar of principal is repaid. It represents the average number of years for principal to be returned to investors, taking into account both scheduled principal payments and anticipated prepayments. WAL is an output that is directly influenced by the prepayment speed.
The confusion arises because both metrics relate to the timing of principal repayment. However, prepayment speed describes the pace of early repayments, while WAL describes the overall effective maturity of the security, which is significantly shaped by that pace. If prepayment speed increases, WAL decreases, as principal is returned sooner. If prepayment speed slows, WAL increases, as principal repayment takes longer.
FAQs
What causes prepayment speed to change?
Prepayment speed is primarily influenced by changes in Interest Rates. When interest rates fall, borrowers have a strong incentive to Refinancing their existing loans at a lower rate, which increases prepayment speed. Other factors include home sales (borrowers pay off their mortgage when selling their home), economic conditions (job security, housing market strength), and specific loan characteristics (e.g., presence of prepayment penalties).
Is a high prepayment speed good or bad for investors?
It depends on the investor's position and the prevailing Interest Rate environment. For investors holding Mortgage-Backed Security (MBS) with high coupon rates, a high prepayment speed means they receive their Principal back sooner, but they then have to reinvest that money at lower market rates, potentially reducing their overall Yield. This is known as "reinvestment risk" or "contraction risk" and is generally considered undesirable for such investors. Conversely, if an investor holds low-coupon MBS and rates rise, low prepayment speeds (extension risk) can be problematic.
How is prepayment speed typically expressed?
Prepayment speed is most commonly expressed as a percentage using either the Single Monthly Mortality (SMM) rate or the Conditional Prepayment Rate (CPR). SMM indicates the percentage of the outstanding loan balance that prepays in a given month, while CPR annualizes that monthly rate to provide an estimated annual prepayment rate for the loan pool.
What is prepayment risk?
Prepayment risk is the risk that the Principal of a Fixed Income security will be returned to the investor earlier than expected. This risk is particularly relevant for Mortgage-Backed Security (MBS) and other debt instruments with embedded prepayment options, such as residential mortgages. It exposes investors to the uncertainty of future cash flows and the potential need to reinvest principal at less favorable rates.