Taking Stock of Bonds

November 13, 2007

Answered Prayers

Answered prayers can turn out to be a nightmare, and this may be the case for the multi-trillion dollar mortgage debt mart. Some well-meaning government policy makers have floated the notion that consumers with costly home loans should be able to get an extension on their mortgages.

 Well, what happens if everyone starts asking for more time to pay off a loan? For now, Wall Street would welcome any balm to promote calm. But when things settle down - as they will - and if we get massive requests for extensions, the cost of borrowing could rise.

How? A wave of loan extensions would throw off projections known as prepayment assumptions - Wall Street calls it a CPR, or constant prepayment rate, an important factor in valuing a mortgage security. Investors spend lots of money rebalancing their folios to manage extension and prepayment risk. Prepayments are bad because they force investors to reinvest their money at a lower rate; extension risk also can impact the value of an investor's folio.

Wall Street, for the last two decades, has spent a great deal of money developing models to understand borrower behavior. Nuances such as geography, loan size and the age of a mortgage play into determining which bonds experience the most loan refinancings. Much of this modeling of loans bundled into bonds could be skewed by a massive wave of mortgage payment extensions. If lenders - with the encouragement of government policymakers - extend the paydown of home loans this could create uncertainty among mortgage debt investors and it could translate into higher costs for consumers. 

Fund managers and Wall Street will want to understand how mortgages in a security perform when home loan extensions are granted. As a result, buyers of bonds backed by mortgage debt will demand a higher premium for taking on risk. That higher yield premium will then be passed on to home buyers.