Academic journal article Business Economics

Does Prepayment Risk of Mortgages Affect Excess Returns of Bank Stocks? the Evidence Suggests That It Does

Academic journal article Business Economics

Does Prepayment Risk of Mortgages Affect Excess Returns of Bank Stocks? the Evidence Suggests That It Does

Article excerpt

This paper explores the relationship between the prepayment risk embedded in conventional, fixed-rate residential mortgages and excess returns for bank stocks. There are two interesting findings in this study. First, commercial banks traded in the Nasdaq market are more mean-variance efficient than the other seven groups of industrial stocks. Second, the prepayment risk factor is significant for these banks. The prepayment risk mainly reflects a call option embedded in a mortgage plus foreclosure costs associated with a mortgage put option. This risk is measured by a remaining part of mortgage rates after excluding the influence of real estate market, maturity, and default risks on mortgage rates. The results of this study suggest that the prepayment risk factor does significantly affect excess returns for bank stocks in the period with high levels of mortgage refinancing activities.

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Compared with other types of loans, mortgage loans embed a unique risk, prepayment risk, in addition to maturity (term) and default risks. In the case of residential mortgages, a homeowner may exercise either a call option (refinancing) to prepay the loan balance without paying any financial penalties if new mortgage rates are lower, or a put option to default--the homeowner is to "put" the house to the bank and let the bank foreclose the property--if the net worth is negative (i.e., if the market value of the property is less than the mortgage loan balance).

In either case, the mortgage is closed before its maturity. The prepayment risk mainly reflects the first case, however. When the homeowner prepays (calls back) the mortgage, the lender faces a reinvestment problem: lower interest rates on new mortgages. In order to compensate the loss on interest revenue, a prepayment risk premium must be included in mortgage interest rates. It is similar to a call premium embedded in a call price for a callable corporate bond. Essentially, a mortgage is a callable bond issued by a home buyer (borrower). There are two different risks contained in a put option. The first is the probability of defaulting on a mortgage, which is measured by the default risk--the chance of losing some interest and possibly losing some principal. The second is the probability of a foreclosure. Only the possible foreclosure costs, in the case of negative net worth, are reflected in the prepayment risk premium, because the bank is responsible for the foreclosure costs. (1) Therefore, prepayment risk is an additional risk for banks engaged in mortgage lending.

Fratantoni and Schuh (2002) note that the "prepayment risk is generally more important empirically than the default risk in most economic environments, since single-family mortgages have very low credit risk relative to other types of loans." Furthermore, according to Bennet, Peach, and Peristiani (2001), homeowners' propensity to prepay or refinance increased in the 1990s relative to 1980s, due to some structural changes in the mortgage market discussed below. In order to compensate lenders for taking prepayment risk, mortgage rates--the required returns on mortgage loans--should contain a premium for this risk. However, the prepayment risk premium is not easy to quantify because it is not observable. In many previous studies, estimation of the prepayment risk premium is included in the context of mortgage pricing (Hendershott and Order, 1987). Other studies try to use more direct methods to quantify the prepayment risk premium. For instance, Bennet et al. (2001) use option values on ten-year U.S. Treasury note futures contracts as a proxy for the prepayment premium. This measure may not be accurate enough to reflect the option values embedded in mortgages. Unlike the option on Treasury notes, mortgage refinancings can be the result of different motivations, ranging from lowering monthly mortgage payments to shortening the maturity of mortgages (Lekkas, 1993). Therefore, a better alternative measure of prepayment premium needs to be developed based on mortgage rates and real estate markets. …

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