Your Money – Mortgage Loan: Default risk and pre-payment speed

July 26, 2021 12:45 AM

The most uncertain part of a mortgage loan is the rate of pre-payment

The most uncertain part of a mortgage loan is the rate of prepayment.The most uncertain part of a mortgage loan is the rate of prepayment.

By Sunil Parameswaran

Mortgage loans are large and indivisible. Consequently, selling whole loans, while feasible in principle, may be hard in practice. Hence, while markets for such loans exist, the liquidity is low and the bid-ask spreads are therefore high. These illiquid assets can however be converted to liquid marketable securities by a process known as securitisation.

Default risk
An agency, termed as a conduit, will acquire and aggregate mortgage loans. It will then issue debt securities, backed by the underlying mortgage loans, which serve as collateral. These securities are usually very liquid in practice. Also, the investment per unit of the security is small. Finally, by investing in one security, the investor is exposed to the average default risk of the underlying loans. In contrast, anyone who invests in a mortgage loan is exposed to the default risk of that loan in its entirety. The conduit may be a government entity, a quasi-government entity, or a private entity. The US has the Government National Mortgage Association (GNMA), whose securities are known as GinnieMaes; the Federal National Mortgage Association (FNMA), whose securities are known as Fannie Maes; and the Federal Home Loan Mortgage Corporation (FHLMC), whose securities are known as Freddie Macs.

Rate of pre-payment
The most uncertain part of a mortgage loan is the rate of prepayment. Thus, we cannot value mortgage-backed securities, without making an assumption about pre-payments. The prepayment rate that is assumed is called the prepayment speed. The monthly prepayment rate is known as Single Month Mortality or SMM.

What it means is as follows. Suppose the scheduled outstanding balance at the end of a month is 200,000. The term scheduled outstanding means that it is the outstanding balance that will be observed, if the homeowner pays the scheduled principal component of the equated monthly instalment (EMI), and does not make a prepayment. If the SMM is 2.50% then the prepayment will be 200,000 x 0.025 = 5,000. Consequently, the actual outstanding amount at the end of the month will be 195,000. Higher the assumed prepayment speed, lower will be the actual outstanding, for a given scheduled outstanding.

Pre-payment may also be expressed in terms of an annual statistic called the Conditional Prepayment Rate (CPR). The CPR may be expressed as follows. One minus the CPR is equal to one minus the SMM, raised to the power of 12.

The normal practice is to assume a low SMM for the initial life of the mortgage. This is because in practice, most homebuyers are unlikely to sell the home in the earlier years, which in practice is one of the major reasons for prepayment. Also, relatively new borrowers are unlikely to refinance their loans to access lower mortgage interest rates, which is another key reason for prepayments.

The writer is CEO, Tarheel Consultancy Services

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