Question

You are a mortgage-backed securities investor with a broad portfolio of bonds backed by home mortgages. In recent times, interest rates have fallen drastically, and as a result many homeowners have begun to refinance their mortgages. What does this refinancing "wave" do for your expected returns? The best answers will be in terms of both reinvestment risk and the convexity properties of mortgage backed securities.

Answer 1

Mortgage-backed security

The investor who buys a mortgage-backed security is essentially lending money to home buyers. An MBS can be bought and sold through a broker. ... Mortgage-backed securities loaded up with subprime loans played a central role in the financial crisis that began in 2007 and wiped out trillions of dollars in wealth.

Subprime mortgage crisis

The subprime mortgage crisis occurred when banks sold too many mortgages to feed the demand for mortgage-backed securities sold through the secondary market. When home prices fell in 2006, it triggered defaults. The risk spread into mutual funds, pension funds, and corporations who owned these derivatives.

What Is a Refinance?

A refinance occurs when an individual or business revises the interest rate, payment schedule, and terms of a previous credit agreement. Debtors will often choose to refinance a loan agreement when the interest rate environment has substantially changed, causing potential savings on debt payments from a new agreement.

How Refinancing Works

A refinance involves the reevaluation of a person or business's credit terms and credit status. Consumer loans typically considered for refinancing include mortgage loans, car loans, and student loans.

Business investors may also seek to refinance mortgage loans on commercial properties. Many business investors will also evaluate their corporate balance sheets for business loans issued by creditors that could benefit from lower market rates or an improved credit profile.

Refinancing occurs when a person or business changes the interest rate, payback schedule, and terms of an already existent agreement

The current rate environment is typically a key catalyst for loan refinancing. Other factors that trigger a refinance can be an improved credit profile or a change in long-term financial plans.

KEY TAKEAWAYS

• A refinance occurs when a previous loan has been revised in terms of the interest rate, payment schedule, and terms.
• A refinance involves the reevaluation of a person or business's credit terms and credit status.
• Consumer loans often considered for refinancing include mortgage loans, car loans, and student loans.

A common goal is to pay less interest over the life of the loan. Borrowers may also want to change the duration of the loan or switch from a fixed-rate to an adjustable-rate mortgage, or vice versa.

Reinvestment risk- refers to the possibility that an investor will be unable to reinvest cash flows (e.g., coupon payments) at a rate comparable to their current rate of return. Zero-coupon bonds are the only fixed-income security to have no investment risk since they issue no coupon payments.

Most mortgage-backed securities (MBS) will have negative convexity because their yield is typically higher than traditional bonds. As a result, it would take a significant rise in yields to make an existing holder of an MBS to have a lower yield, or less attractive, than the current market