One of the most significant risks in the case of mortgage pass-through security is the risk that investors receive cash flows when they do not expect them. This is called prepayment risk, and it has two components: contraction risk and extension risk.
Contraction risk
The risk that borrowers will prepay their mortgages by refinancing their loans when interest rates are low is called contraction risk.
Contraction risk has two adverse effects:
- It forces investors in mortgage pass-through securities to invest prepaid amounts at low interest, and
- The price appreciation potential of investments when prepayment risk is high is limited.
Extension risk
The risk that in a high-interest rate environment, borrowers will prepay less of their loans because the interest rate on existing mortgages is lower than the market interest rate. This causes the investors to earn low interest in a high-interest environment and the value of mortgage pass-through security declines. This is called extension risk.
Prepayment rate measures
Accurate estimation of the prepayment rate is important for the correct valuation of mortgage pass-through securities. There are two prepayment rate measures, the single monthly mortality rate (SMM) and its annualized version called conditional prepayment rate (CPR).
The single monthly mortality rate is calculated using the following formula:
\[ SMM=\frac{MPP}{OB – SRP} \]Where MPP is the monthly prepayment, OB is the opening balance of the mortgage and SRP is the scheduled repayment of principal.
Conditional prepayment rate (CPR) is the annualized SMM and it expresses the percentage of total mortgages that will be repaid in a year.
PSA prepayment rate
In the US, prepayment rates are expressed in terms of the Public Securities Association (PSA) prepayment, which is the monthly prepayment rate created on the assumption that prepayment rates for new issues are low and that they increase as the mortgages become seasoned. The standard PSA is 100 and any PSA greater (lower) than 100 means faster (slower) prepayment.
Even though a mortgage pass-through security has a legal maturity, the date on which the last payment is received from underlying mortgages, it tells little about the actual interest rate risk. It is because most mortgages are amortizing, and the principal repayment and prepayment are significant. While effective duration is a sound indicator of interest rate risk, market practitioners often calculate weighted average life (or average life) of the mortgages, the time they expect to hold the securities before they are paid. The average life depends on prepayment assumption, for example at 100 PSA, average life is 11.2, at 400 PSA, it is 4.5 and at 600, it is 3.2