How does mortgage prepayment risk affect a bank's ALM?

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AcadiFi · Accepted Answer

Prepayment risk is the option mortgage borrowers hold to repay early, typically by refinancing when rates fall. Banks that hold mortgages (or MBS) are effectively short that option, receiving a yield premium in exchange for negative convexity: when rates fall, prepayment accelerates and the bank loses high-coupon assets just when it most wants to hold them; when rates rise, prepayment slows and duration extends exactly when the bank wants shorter assets. This is extension risk. ALM modeling uses a prepayment function CPR (conditional prepayment rate) driven by refinancing incentive (coupon minus current rate), burnout (borrowers who have not refi'd despite incentive), seasonality, and turnover. Example: a pool of $500M in 30-year 5% mortgages has base CPR of 8%. A 150 bp rate drop triggers refinancing; CPR spikes to 40%, returning cash to the bank at 3% reinvestment rates rather than 5%. Annualized NII loss from reinvestment drag is roughly $500M * (0.40 - 0.08) * (0.05 - 0.03) = $3.2M. ALM hedges prepayment convexity using interest rate swaptions (receiver swaptions benefit as rates fall and prepayment accelerates) or by holding interest-only MBS strips. Effective duration replaces modified duration because it incorporates how the option-adjusted cash flow schedule changes under rate shocks. Prepayment is one of the three IRRBB option-risk subcomponents alongside depositor early-withdrawal and embedded caps/floors.

How does mortgage prepayment risk affect a bank's ALM?

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