Burnout (Mortgage-Backed Securities) – Definition
Burnout refers to a timeframe during which the prepayment rates of a mortgage-backed security lower down in spite of declining rates of interest. With reducing interest rates, the mortgage holders get an opportunity to be involved in refinancing strategies. In case, they are unable to take advantage of refinance, it leads to burnout. There is a presumption that most of the debtors refinanced before the stage when interest rates reduced, and the remaining ones find it difficult to do so because of several factors such as absence of equity, or poor credit rating. The term burnout ascertains the price of mortgage-backed securities. It can also be penned down as ‘burn-out’ and also known as ‘burnout phenomenon’ or ‘refinancing burnout’.
A Little More on What is Burnout in Mortgage Backed Securities
Burnout and interest rates are related to each other. In case, there is a decline in interest rates during a specific month, it leads to a bigger single monthly mortality, usually a bigger amount of principal reimbursements on the mortgage-backed security. MBS holders can consider prepayments as an unfavorable phenomenon because of receiving money quicker than expected, and losing out on interest. This prevents the MBS holder to receive larger amounts of interest throughout the MBS period. Also, the investor needs to make reinvestments and refinancing strategies at less interest rates. The fall in interest rates makes the MBS investors suspicious about fresh market issues and their current security portfolios. However, the situation becomes fascinating when interest rates continue declining over a continuous period of time. Rather than observing the rising prepayment on underlying mortgages, the single monthly mortality rate will tend to balance the risks, and sometimes, it could even get back to the previous average amount that calls for a burnout. This can be used for pricing models considering past or historical information.
Factors that Influence Refinancing Burnout
When there is a finalization of loans done before the falling of interest rate, there will be a stage that would influence to reinvest at a lesser rate instead of sticking to the current mortgage. A borrower can refinance based on several factors. Every province has different fixed costs associated with refinancing. Also, these costs may vary as per the tenure of each mortgage or loan. Individuals would resist to refinance in case the fixed expenses related to refinancing are more, until savings derived from interest rates are even bigger. This is what influences them to refinance initially when interest rates start decreasing. So, instead of waiting, then tend to think economically, and take benefit from the situation. This can be usually because these individuals can manage bearing high refinancing costs as their savings, present equity, and debt condition may not be as amazing as the group having a great credit standing. After the group having more credit standing refinances, there are high probabilities of refinancing burnouts coming in the picture.
A mortgage-backed security has several interest rate stages throughout its tenure, making them more lucrative post burnout. This signifies a fall in the risk of prepayment ahead.