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Burnout (Mortgage-Backed Securities) Definition
Despite lowering interest rates, mortgage-backed security (MBS) pre-payment rates slow down over time and this is described as Burnout. Mortgage holders have an incentive to refinance when the interest rates drop on the substratal MBS. When refinance fails it is credited to Burnout. Factors such as a drop in creditworthiness, lack of property equity affect many borrowers, while other borrowers appear to have refinanced early in the drop cycle of the interest rates. Mortgage-backed securities are evaluated through risk models of burnout so they can be properly priced. “Refinancing burnout” and “burnout phenomenon” are two other names for burnout which can also be spelled as “burn-out”.
A Little Bit More on Burnout in Mortgage Backed Securities
The interest rate environment is tied to burnout. In any given month interest rates can fall, which reveals a higher single monthly mortality that in essence is a greater MBS principal repayment. For the MBS holder prepayment is dissentious because even though they gain their money back quicker, it doesn’t include interest. The investor is stuck with a low interest rate environment to reinvest into because of the reduction in interest generated on the overall MBS. When interest rates dip, MBS investors closely review new issues within their existing portfolios. Over a period of months as the interest rates become weaker it can get interesting. The single monthly mortality rate will revert back to the historical average and will level off instead of these underlying loans increasing prepayment. Using statistical and historical data this burnout can be worked into pricing models and risk to see the return to average.
There are times when refinancing to a lower rate makes more sense than holding on to the existing loan on any mortgage that was completed before the interest rate drop. The burnout is influenced by the borrower’s ability to refinance and the number of factors that affect it. According to a loans terms there are fixed costs for refinancing that will differ state to state. If the interest savings is greater than the fixed costs most people won’t be reluctant to refinance. Borrowers with high credit scores will be eager to finance according to the data available. In essence, the borrow will make fast decisions about refinancing in the early stages of declining interest rates instead of waiting it out making more sense economically. This decision is possibly due to the opportunity available, however other borrowers with lower credit ratings will be unable to take on the refinancing costs due to the burden of overall debt, savings, and built-up equity. What we see here is the burnout sets in after the group with the higher credit ratings have refinanced.
After the burnout has occurred, the risks associated with prepayment in the proximal future will drop as the MBS goes through cycles of interest rates throughout it’s term.
References for Burn Out