Prepayment Risk Turns a Mortgage Security Into a Moving Target
Homeowners can repay early whenever they choose, and they choose to when rates fall. That single freedom makes mortgage securities the most complicated instrument in high quality fixed income.
The Free Option
A homeowner with a thirty year fixed mortgage can repay the whole balance at any time, usually with no penalty. They typically do this by refinancing when rates fall, or by selling the house.
That right is an option, granted to the borrower and paid for by whoever holds the loan. It is unusual because it is not priced explicitly and the holder cannot decline it.
Bundle thousands of those loans into a mortgage backed security and the investor owns a stream of payments that can accelerate without warning. The stated maturity is thirty years. The actual life is unknown.
Why Timing Runs Against You
Borrowers refinance when rates drop. That is when your high yielding loans disappear and you receive principal back to reinvest in a lower rate world.
When rates rise, borrowers stay exactly where they are. Your below market loans persist, and the security's effective life extends just as you would most like your money back.
Contraction when you want duration, extension when you want cash. The homeowner is not trying to hurt you, but the aggregate behaviour lines up against the investor every time.
These are called contraction risk and extension risk, and together they produce the same negative convexity that callable bonds carry, for the same underlying reason.
What Drives Prepayment
| Driver | Effect |
|---|---|
| Rate incentive versus existing loan | The dominant factor |
| Home sales and relocation | Steady baseline turnover |
| Seasonality | Higher in spring and summer |
| Loan age | Ramps up over the first years |
| Credit and equity position | Constrains who can refinance |
Behaviour is not purely rational. Some borrowers refinance at the first opportunity, and others never do despite a clear saving, from inertia, closing costs, or not qualifying. This burnout effect means a pool that has already been through a refinancing wave contains disproportionately many borrowers who will not act, and prepays more slowly than a fresh pool at the same rate incentive.
The 2020 to 2023 Whipsaw
The recent cycle demonstrated both sides at full scale. In 2020 and 2021, with mortgage rates at historic lows, refinancing ran at extraordinary volume and mortgage holders received principal back constantly, reinvesting at the lowest yields available in decades.
Then rates rose sharply. Millions of borrowers now held mortgages far below market and had no reason to move at all, since moving meant surrendering the rate. Prepayments collapsed to minimal levels, and mortgage securities extended in duration exactly as rates rose and losses mounted.
The same population produced maximum contraction and then maximum extension within roughly two years.
How It Gets Managed
Because the security's duration changes as rates change, hedging it requires constant adjustment. When rates rise, mortgage portfolios extend, and holders sell Treasuries or pay fixed on swaps to shorten back. That hedging flow is itself large enough to amplify moves in the Treasury market, a mechanism sometimes visible during rapid selloffs.
Structured products were the other response. Collateralised mortgage obligations slice the cash flows into tranches with different prepayment exposures, so investors can choose a profile. This distributes the risk. It does not remove it, and the more exotic tranches concentrate it severely.
The Bottom Line
A mortgage backed security is a bond whose life is decided by the refinancing decisions of thousands of households. They accelerate repayment when rates fall and stop when rates rise, which is the wrong direction both times. That is prepayment risk, it produces negative convexity, and it is why agency mortgages demand a spread over Treasuries despite carrying effectively no default risk.