Mortgage-Backed Securities: Products, Structuring, and Analytical Techniques

CHAPTER 4

Prepayment Behavior and Performance

A critical component in the valuation, risk management, and trading of mortgage-backed securities (MBS) is prepayments. The rate of prepayments, or prepayment “speed,” impacts MBS values in a number of ways. Because of this, large amounts of resources and many personnel hours are expended by investors and dealers in understanding and modeling prepayment behavior. However, refinancing behavior and prepayment performance are not static, and have changed significantly since the first prepayment waves were experienced in the early 1990s. This is due to a number of factors: rapid real estate appreciation in the United States, the growth of the adjustable rate mortgage (ARM) market, and the development of a more consumer-friendly mortgage industry. While not intended to be a comprehensive study of prepayment behavior, this chapter addresses the underlying factors driving prepayment and refinancing behavior, while also addressing why prepayment behavior has changed from the early 1990s to the current period. We will also attempt to identify additional factors affecting prepayment speeds, including loan size, credit performance and geography, as well as factors unique to different mortgage products and product sectors.