Prepayments and their impact on principal cash flows are critical components of the valuation, trading, and risk management of mortgage-backed securities. Because of this, substantial resources are expended by investors and dealers in understanding and modeling prepayment “speeds.” However, prepayment behavior is not static, and has evolved repeatedly since the first prepayment waves in the early 1990s. Moreover, the very definition of “prepayments” has evolved from one focused primarily on borrowers' refinancing options to one encompassing a plethora of actions and decisions.
While not intended as a comprehensive study of prepayment behavior, this chapter discusses the underlying factors impacting principal repayment rates. We also draw distinctions between the traditional view of prepayments and a broader one that puts credit-related factors into context.
As noted in the introduction, traditional prepayment analysis has focused on borrowers' option to retire their loans prior to maturity. Virtually all mortgage loans allow for the early repayment of principal. Prepayment behavior can be divided into several categories. The first of these is referred to as turnover, which occurs when the underlying properties are sold and the associated loan is retired. Turnover can occur for a number of reasons: