Your money is a mortgage loan: the risk of default and the speed of prepayment

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The most uncertain part of a mortgage loan is the amount of early repayment.The most uncertain part of a mortgage loan is the amount of early repayment.

Written by Sunil Parameshwaran

Mortgages are large and indivisible. Consequently, selling loans in whole, while possible in principle, can be difficult in practice. Consequently, although markets for such loans exist, liquidity is low and therefore spreads between buyers and buyers are high. However, these illiquid assets can be converted into liquid marketable securities through a process known as securitization.

The usual risk
The agency, called the channel, will acquire and aggregate mortgage loans. It will then issue debt securities backed by matching mortgages that serve as collateral. In practice, these securities are usually very liquid. Also small investments per unit of security. Finally, by investing in one security, the investor is exposed to the average risk of default on the underlying loans. In contrast, anyone who invests in a mortgage loan runs the risk of default on that loan as a whole. The channel can be a government agency, a quasi government agency, or a private organization. In the US, there is the State 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 Credit Corporation (FHLMC), whose securities are known as Freddie Macs.

Prepayment rate
The most uncertain part of a mortgage loan is the amount of early repayment. Therefore, we cannot value mortgage-backed securities without making assumptions about a prepayment. The estimated prepayment rate is called the prepayment rate. The monthly prepayment rate is known as one month mortality or SMM.

This means the following. Suppose the planned outstanding balance at the end of the month is 200,000. The term “planned debt” means that the outstanding balance will be honored if the landlord pays the planned EMI principal principal and does not make an advance payment. If SMM is 2.50%, then the prepayment will be 200,000 x 0.025 = 5,000. Therefore, the actual amount owed at the end of the month will be 195,000. The higher the estimated rate of prepayment, the lower the actual outstanding debt will be for this planned debt.

The prepayment can also be expressed as an annual statistic called the Conditional Prepayment Rate (CPR). CPR can be expressed as follows. One minus gearbox is equal to one minus CMM to the 12th power.

It is common practice to assume low SMM during the initial term of the mortgage. This is because, in practice, most home buyers are unlikely to sell a home in earlier years, which in practice is one of the main reasons for prepayment. In addition, relatively new borrowers are unlikely to refinance their loans to gain access to lower mortgage interest rates, another key reason for early repayments.

The author is the CEO of Tarheel Consultancy Services.

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