Pre-payments are reducing value of mortgage-backed securities

If you read my recent post on How big banks earned so much money this quarter you would see that much of the income at Wells, JPMorgan, US Bank and others came from refinancing old mortgages. While this may be a boon to present income, it is very much a problem for the legacy mortgage-backed securities which contain the old mortgages. Let me explain.

When I was in business school, I took a course on debt markets with Professor Suresh Sundaresan, which was very helpful for me when I later joined a large bank in London. Professor Sundaresan worked at Lehman Brothers in their fixed income and derivatives area in the mid-1980s and was very familiar with all of the debt products we discussed in class.

One thing I found quite useful about the course was its explanation of the mortgage markets and mortgage-backed securities (MBS).  The mortgage market is a lot more complicated than other bond markets because MBS are not like other bonds. There is an embedded option contained in all mortgages, the pre-payment option, which makes valuation extremely tricky. In Chapter 9 of his book on “Securitization and Mortgage-Backed Securities,” which I have just consulted, Sundaresan talks about prepayment risk and what it means to the lower value of MBS.  He says the following in his book:

Mortgages permit the homeowners to prepay their loans. This prepayment provision introduces timing uncertainty into the originating bank’s cash flows from its loan portfolio. For example, if the bank originates a pool of mortgages with a weighted-average rate of 8% and six months later the mortgage rate drop significantly below 8%, say to 7%, then the loan portfolio is certain to experience significant prepayments as borrowers rush to refinance their mortgages with less-costly loans. The lender has a long position in the mortgage loan that entitles him to monthly scheduled payments, but also has sold an option to the homeowners that gives them the right [but not the obligation] to prepay the loan when the circumstances demand it. This means that the bank cannot predict the future cash flows from its loan portfolio with certainty. Clearly, the option to repay will be priced into the loan by the bank and the borrower will pay a higher interest rate on the loan as a consequence.

Here’s the deal. The bank does not want its customers to pre-pay because that means less income from interest payments for the bank. Less income lowers the value of the mortgage. So, pre-payments are bad for anyone holding debt or derivative instruments related to the expected cash flow of those mortgage loans.

As Sundaresan indicates, the originators and MBS packagers understand this and have tacked on a ‘fee’ in the form of a higher loan interest rate to cover their expected pre-payment risk.

Enter the Federal Reserve. To stave off a deflationary spiral, the Federal Reserve has lowered the effective short-term interest rate to zero and it is in the process of buying up shed loads of MBS paper and long-term bonds in order to artificially reduce long-term rates as well. The problem here lies in the term ‘expected’ from the previous paragraph, because the so-called toxic MBS paper now clogging balance sheets are now unexpectedly pre-paying at a record rate. This lowers the expected cash flow from those assets significantly, making the underlying assets worth even less.

Moreover, there is a certain perverse adverse selection at work here because not everyone can get a loan these days. That means that the individuals pre-paying are likely to be the most qualified borrowers. This leaves existing MBS borrower pools significantly worse off.

For example, say you have a mortgage-backed security collateralized by mortgage assets from prime borrowers. We enter a recession and a number of loans in that pool become distressed and a number of the borrowers in that pool default. This means that your MBS asset is worth less.

Simultaneously, interest rates drop unexpectedly and a number of the borrowers re-finance their mortgage meaning they pre-pay the mortgage in your pool. You are not going to get the interest payments that you had expected to receive. Again, this means that your MBS asset is worth less.

What’s more is that because of the recession, credit conditions are unusually tight and only the best qualified borrowers are refinancing. So the borrowers left in your asset pool are net lower-quality borrowers. Translation: you should now expect a higher default rate of those left in the pool. Again, this means that your MBS asset is worth less.

To sum up:

  1. You just got the shaft because a recession has meant higher default rates generally.
  2. You just got the shaft because of unexpected pre-payment and lower cash flows that result from this.
  3. You just got the shaft because your pool of borrowers has been adversely impacted by the Fed’s interference in the MBS market

All of this is very bad for existing or so-called legacy assets.  Moreover, these assets must be marked-to-market to reflect asset value impairment.  So, this will mean massive writedowns going forward.

But, wait a minute, didn’t we just change the accounting rules? Enter new mark-to-market accounting a.k.a. mark-to-make-believe.  Because of the guidance on marked-to-market accounting in FAS 157-e, you can deem these changes to be temporary impairments.  There is no need to mark to market.  Problem solved.

Here’s what Wells Fargo had to say about its marking-to-market last quarter in their earnings release (PDF):

The net unrealized loss on securities available for sale declined to $4.7 billion at March 31, 2009, from $9.9 billion at December 31, 2008. Approximately $850 million of the improvement was due to declining interest rates and narrower credit spreads. The remainder was due to the early adoption of FAS FSP 157-4, which clarified the use of trading prices in determining fair value for distressed securities in illiquid markets, thus moderating the need to use excessively distressed prices in valuing these securities in illiquid markets as we had done in prior periods.


And if you think people aren’t fooled by all of this, think again. Bank stocks are way, way up.

  1. Anonymous says

    Though i understand your rational on MBS valuations, one question comes to mind, is it not better the good gets seperated from better sooner than later. So instead of the whole world treating an MBS with lets say 50% (pre payment possible) and 50% (non prepayment possible) as same as 100% bad/toxic.

    This creative destruction will eventually help the MBS market (possibly through TALF).

  2. Edward Harrison says

    The problem with the prepayments is that they are making the legacy assets worth even less. So, over the medium-term, these banks will be carrying around assets at inflated prices. It is not clear in the least that all the banks can be adequately recapitalized before they finally must take the losses on those assets

    To the degree that there is a shift from some asset holders to other as the prepayments and refinancing occurs, those institutions holding legacy assets without adequate new streams of cash flow from the refinancing are going to suffer.

    These pre-payments guarantee that someone is going to end up with the Schwarzen Peter.

  3. barryschaeffer says


    Thanks for sharing your hard-earned insights of the mechanics of mortgage pools. At least I hope I won’t get whacked when these chickens come home to roost. Unless the Feds stick me with the bill again…


  4. pwm says

    At the same time, prepayment risk gets replaced with extension risk. And extension risk will matter a lot if the interest rate environment becomes adverse, as we can reasonably expect it to, given a deteriorating ability to service increasing debt levels. Fannie, Freddie, and soon the Fed are the three biggest depositories of this extension risk, unless you want to count the banking system as one entity. I know some of this is laid off in the derivative markets, but it does not disappear, and is very large given the scale of mortgage debt out there.

    Very good post Ed.

    1. Edward Harrison says

      pwm, thanks. Your comments really do point out that there is no free lunch here. The Fed is manipulating rates in a way that is going to have unforeseen consequences, many of them negative. Apparently, the Fed and Treasury believe too much in the power of government to control markets. What really needs to happen is prices need to drop to an equilibrium level and we need to start fresh from that point on.

      If any propping up should be done, it should be for former homeowners, now displaced.

Comments are closed.

This website uses cookies to improve your experience. We'll assume you're ok with this, but you can opt-out if you wish. Accept Read More