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Managing the Risk of Faster Prepayments in Amortizing MBS

July 06, 2020

By Jonathan Jackson, Catalyst Strategic Solutions Senior Advisor, CFA, FRM


Risk of Amortizing MBSCredit union balance sheets look much different than they did at the beginning of 2020. As a result of government stimulus and the economy entering recession, deposit growth exceeded expectations through the first half of the year. High deposit growth combined with low loan demand resulted in excess liquidity on most credit unions’ balance sheets. Excess liquidity and low loan demand mean investment activity has increased substantially. Credit unions added more than $14 billion of investments to their balance sheets in the first quarter of 2020, a 5.7 percent increase from the year-end 2019 level.

Although credit unions have been increasing their investment allocations, the environment for investing has been challenging. Recent Federal Reserve actions, including reducing the overnight rate to a range of 0.0-0.25 percent and purchasing more than $2 trillion of U.S. Treasuries and Agency mortgage-backed securities (MBS), pushed interest rates and investment yields lower and bond prices higher. This low interest rate environment is exposing investors to a higher degree of risk, particularly the risk of faster prepayments in amortizing MBS.

Mortgage rates have declined, and millions of borrowers have mortgages that are now in the money to refinance to a lower rate. Consequently, we can expect prepayments on MBS to be faster than normal. The result of faster prepayments will be lower yields on any MBS investments purchased at a premium. The higher the premium paid, the greater the risk of a low, or even negative, return. Faster prepayments also expose investors to reinvestment risk. The cash flows from these MBS are likely to be reinvested at lower rates in this current rate environment.

One way to lower the risk of premium bonds is to buy MBS investments with lower coupons. A bond with a 2.0 percent coupon will have a lower price than a bond with a 3.0 percent coupon, assuming the bonds have similar underlying collateral. An MBS with a lower coupon will have less premium risk but is likely to have more price volatility. This means the market value of the bond will decline more in a rising rate scenario than a bond with a higher coupon. By buying a bond with a lower coupon, you are trading lower premium risk for higher price volatility.

Look beyond the base case projected yield and average life when reviewing MBS investments. How does the bond perform in faster-than-expected prepayment scenarios? At what CPR speed does the yield result in a 0.0 percent return? There are certain characteristics of mortgages that will likely prepay at slower speeds.

First, mortgage pools with a lower weighted average coupon (WAC) will have less incentive to refinance. Similarly, mortgages with a lower loan size will benefit less from refinancing to a lower mortgage rate. Another characteristic to review is how many loans are in the pool of mortgages? For example, one loan refinancing in an MBS pool with a small number of loans will have a greater impact to the MBS performance than it would in a pool with a higher number of loans.

When reviewing MBS investments, you’ll also want to consider other characteristics that could impact the propensity for prepayments, such as the servicers of the mortgages, the geographic location of the loans, LTV, age of the loans, etc. The key takeaway is that this low rate environment calls for closer scrutiny when purchasing MBS investments.

Catalyst Strategic Solutions trusted team of Advisors have a wealth of knowledge to help your credit union manage your balance sheet and investment portfolio. For more information, contact us today!