Introduction to Securitization

PREPAYMENTS AND PREPAYMENT CONVENTIONS

Different types of loans may permit the borrower to prepay the loans in whole or in part at any time prior to the scheduled principal repayment date. This is certainly the case of the largest asset class that has been securitized in the United States: residential mortgage loans. The payment made by the borrower in excess of the scheduled principal payment is called a prepayment. Estimating the cash flow from collateral that allows prepayments requires making an assumption about future prepayments.

Why are we concerned with prepayments? With a debt obligation, nonpayment or delayed payment is an adverse economic consequence for the debt holder. In contrast, prepayment can be beneficial or harmful to the debt holder depending on the circumstances. Particularly in the case of for long-duration debt instruments such as residential mortgages, the mortgage not being allowed to continue until maturity but instead being prepaid may cause substantial loss of value to the mortgage lender, and upon securitization, to the mortgage-backed securities investor. What makes prepayment painful is that because it is an option granted to the borrower, it is always exercised to the benefit of the borrower and against the lender. For example, a fixed rate mortgage can be prepaid when mortgage rates decline below the loan rate paid by the borrower as the borrower can refinance the mortgage at the prevailing lower rate. An adjustable-rate mortgage may have a ...