How does prepayment risk in MBS create both contraction and extension risk, and how do I analyze it?

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AcadiFi · Accepted Answer

Prepayment risk in mortgage-backed securities (MBS) is unique because it creates **two opposing risks depending on the interest rate environment**. This is one of the most tested Fixed Income topics at CFA Level II.

**The Core Problem:**
When you buy an MBS, you own a pool of mortgage cash flows. Homeowners have the option to prepay their mortgages at any time (typically by refinancing). This embedded call option belongs to the borrower, not the investor — and it works against you in both directions.

**Contraction Risk (Rates Fall)**
- When rates drop from 6.5% to 4.5%, homeowners rush to refinance
- Prepayments accelerate → you get your principal back faster than expected
- **Problem:** You must reinvest at the new lower rates
- The MBS "contracts" — its effective duration shortens just when you want it to be long (to capture price gains from falling rates)

**Extension Risk (Rates Rise)**
- When rates rise from 5% to 7.5%, nobody refinances
- Prepayments slow dramatically → your principal is locked up longer than expected
- **Problem:** You're stuck holding a below-market-rate asset
- The MBS "extends" — its effective duration lengthens just when you want it to be short (to limit price losses from rising rates)

**This is called negative convexity** — the MBS behaves in the worst possible way in both scenarios.

**The PSA Prepayment Model:**

The Public Securities Association (PSA) benchmark assumes:
- Month 1: 0.2% annual prepayment rate (CPR)
- Increases linearly by 0.2% per month
- Month 30+: Levels off at 6% CPR

This is the "100% PSA" baseline. Actual prepayments are expressed relative to this:
- **150% PSA** = prepayments are 1.5x the benchmark (faster than normal)
- **75% PSA** = prepayments are 0.75x the benchmark (slower than normal)

**Worked Example:**
Northbridge Capital holds a $50 million MBS pass-through with a 5.5% coupon, priced at 101 with an expected average life of 8.2 years at 100% PSA.

| Scenario | PSA Speed | Avg Life | Effect |
|---|---|---|---|
| Rates fall 200 bps | 250% PSA | 3.8 years | Contraction — principal returned too fast |
| Rates unchanged | 100% PSA | 8.2 years | Baseline |
| Rates rise 200 bps | 50% PSA | 14.1 years | Extension — stuck in low-coupon bond |

At 250% PSA, Northbridge receives $50M back over ~4 years but can only reinvest at 3.5% instead of 5.5%. At 50% PSA, the portfolio is effectively a 14-year bond in a 7.5% rate environment.

**Tranching as a Solution:**
Collateralized Mortgage Obligations (CMOs) address prepayment risk by creating tranches:
- **Sequential-pay tranches:** Tranche A absorbs prepayments first, giving Tranche B more predictable cash flows
- **PAC (Planned Amortization Class):** Has a scheduled principal payment pattern that holds as long as prepayments stay within a "collar" (e.g., 80-250% PSA)
- **Support tranches:** Absorb excess prepayment variability to protect PAC tranches — these carry the most prepayment risk

**Exam Tip:** When a vignette asks about the risk of an MBS in a falling rate environment, the answer is contraction risk and reinvestment risk. In a rising rate environment, it's extension risk. If asked which CMO tranche has the most prepayment risk, it's always the support tranche.

Explore more MBS analysis in our CFA Level II course materials.

How does prepayment risk in MBS create both contraction and extension risk, and how do I analyze it?

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