Thursday, July 24, 2008

Extension Risk and Mortgage Backed Securities

I'll probably be teaching Fixed Income class next year when a colleague goes on sabbatical. I'll try as much as possible to tie the class in with the CFA curriculum. One of the big topics in the Level 2 CFA Fixed Income material is the issue of extension and contraction risk for mortgage backed securities (MBS).

In case you're not familiar with the terms, contraction risk is the risk that repayments of principal on the mortgages underlying the MBS will be higher than expected, thereby resulting in a lower than expected maturity on the security. Extension risk is the opposite (lower than expected repayments, and a stretching of the MBS security's maturity.

Accrued Interest just put up a great piece on the topic. In short, it talks about how the problems in the mortgage markets will result in extension risk being higher than expected. The general drop in the real estate market has resulting in people having lower than expected equity in their homes (in some cases, they're "upside down", with home values lower than the outstanding balance). In addition, lenders have become very skittish about lending with less than 20% equity. So, there will be less refinancing activity than in predicted in most pricing models. As a result, there'll be a lengthening in the average maturity of the typical MBS (i.e. more extension risk).

Read the whole thing here.