Prepayment Risk

Every amortizing loan in a securitized pool carries the borrower's right to repay principal ahead of schedule, usually without penalty in the US residential market. That right is economically a call option written by the investor and granted to the borrower, so the pool's cash flows are contingent rather than contractual. Prepayments arrive as full payoffs on refinancing, as curtailments when a borrower makes extra principal payments, as payoffs on home sale, and, in guaranteed agency pools, as insurance advances when a loan defaults, which reach the investor as an early return of principal rather than a credit loss.

The consequence is that principal returns to the investor at times the investor did not choose. Faster repayment forces reinvestment, typically into the lower-rate environment that caused the refinancing. Slower repayment locks capital into a below-market coupon precisely when higher-yielding alternatives exist. Neither outcome is a default; both destroy value relative to the scheduled profile.

The dominant driver is the spread between the pool's weighted average coupon and prevailing mortgage rates: the deeper a loan is in the money, the stronger the refinancing incentive. But several drivers operate independently of rates. Housing turnover generates prepayments whenever a property is sold, so employment mobility and home-price appreciation matter. Seasoning matters because newly originated loans prepay slowly before ramping toward a stable pace. Seasonality shows up in spring and summer home sales. Burnout describes pools whose most rate-sensitive borrowers have already refinanced, leaving a residual population that responds weakly to further rate declines.

Frictions also cap the response. Refinancing costs, credit impairment, insufficient home equity, and loan size all determine whether an in-the-money borrower actually acts. This is why prepayment models are behavioural and statistical rather than purely arbitrage-based, and why two pools with identical coupons can prepay very differently.

The single monthly mortality rate is the month's prepaid principal divided by the pool balance available to prepay, that is the beginning-of-month balance less the scheduled principal payment for that month. Annualising compounds the survival rate: the conditional prepayment rate equals one minus the twelfth power of one minus the SMM. A 6% CPR therefore means roughly 6% of the outstanding pool, beyond scheduled amortization, is expected to disappear over the year.

The PSA convention expresses a ramp rather than a constant. The 100 PSA benchmark starts at a 0.2% CPR in the first month, rises by 0.2% each month until it reaches 6% at month thirty, then holds flat. A quote of 200 PSA doubles that path at every point; 50 PSA halves it. Feeding an assumed path into the amortization schedule produces the projected cash flows from which weighted average life, price and yield are computed, which is why every MBS quote is conditional on a prepayment assumption.

Securitization does not remove prepayment risk; it redistributes it. Sequential-pay CMOs concentrate contraction risk in early tranches and extension risk in later ones. Planned amortization classes deliver a stable schedule across a specified PSA band by pushing variability into support tranches, which absorb both extremes. Interest-only strips lose value when prepayments accelerate because the interest-bearing balance vanishes, while principal-only strips gain; this makes IOs one of the few instruments whose price can rise as rates rise. Non-mortgage ABS behaves differently: auto loans prepay modestly and are protected by rapid amortization, and credit card structures use lockout periods to fix principal timing.

At Level I, be able to convert SMM to CPR and interpret a PSA quote, distinguish contraction from extension risk and identify which tranche or strip suffers from each, explain negative convexity and the resulting compression of price gains, and justify why option-adjusted spread rather than nominal or zero-volatility spread is the appropriate relative-value measure for a security whose cash flows depend on the interest rate path.