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

RISKS ASSOCIATED WITH MORTGAGES AND MORTGAGE PRODUCTS

Holders of fixed income investments ordinarily deal with interest rate risk, or the risk that changes in the level of market interest rates will cause fluctuations in the market value of such investments. However, mortgages and associated mortgage products have additional risks associated with them that are unique to the products and require additional analysis. We conclude this chapter with a discussion of these risks.

Prepayment Risk

In a previous section, we noted that obligors have the ability to prepay their loans before they mature. For the holder of the mortgage asset, the borrower’s prepayment option creates a unique form of risk. In cases where the obligor refinances the loan in order to capitalize on a drop in market rates, the investor has a high-yielding asset pay off, and it can be replaced only with an asset carrying a lower yield. Prepayment risk is analogous to “call risk” for corporate and municipal bonds in terms of its impact on returns, and also creates uncertainty with respect to the timing of investors’ cash flows. In addition, changing prepayment “speeds” due to interest rate moves cause variations in the cash flows of mortgages and securities collateralized by mortgage products, strongly influencing their relative performance and making them difficult and expensive to hedge.

While we address both the factors driving prepayment behavior and the metrics used to measure prepayment speeds later in ...