In
the last post we discussed the two types of prepayment risk: interest rate risk
and equity prepayment risk. In this
post, we focus exclusively on how equity prepayment risk affects each mortgages
and student loans. We note that there
are fundamental differences between the loan types that make using similar credit
analyses impossible.
Equity
prepayment risk is derived entirely from the change in the credit quality (e.g.
default risk) of the borrower. A
borrower will only be incentivized to refinance into a lower rate if their
credit quality has improved significantly since the loan was originated. Thus, in order to analyze equity prepayment
risk, we need to review the evolution of credit quality in both mortgages and
student loans:
The
traditional mortgage is a secured loan that is collateralized by the real
estate asset (the house) with a loan-to-value of no greater than 80% (20% down
payment). As a result, the vast majority
of the credit quality of a mortgage is dependent upon the value of the
underlying home as collateral: if the borrower defaults the bank can foreclose
on the home and sell it for 80% of its original value without taking any
losses. Thus, the evolution of credit quality
for a mortgage is almost entirely derived from the change in value of the
underlying home. The last decade
notwithstanding, U.S. home prices have historically been very stable. Consequently, the evolution of credit quality
of mortgage borrowers is very gradual as well and thus we would expect the effect
of equity prepayment risk to be minimal.
The exception to this rule is in instances where housing prices increase
dramatically in a short period of time.
In this case, we would expect homeowners to rapidly and consistently
refinance their mortgages as the value of the underlying collateral
increased. This is precisely what
occurred from 2002 to 2007 during the housing bubble.
Student
loans are not like mortgages. Student loans
are unsecured debt whose underlying credit quality is solely determined
by the expected future income of the borrower (and cosigner). The credit quality of a student loan will
evolve with direct proportion to the certainty regarding the borrower’s ability
to earn an income commensurate with their debt level. This figure, however, is extremely volatile
in the early years of a student loan.
Key binary metrics that determine credit quality evolve dramatically
over the student’s educational period, most notably: the likelihood that the
student will graduate and the likelihood that they will attain a high paying
job post-graduation. In fact, the failures
to adequately meet these qualifications are the top two causes of student loan
default. As a result, the evolution of
credit quality in student loans is extremely steep: 70% of defaults occur
within the first two years of a loan entering repayment.
This phenomenon reflects the huge level of
uncertainty and variability in the value of higher education degrees. More importantly, this phenomenon would lead
us to believe that there is enormous equity prepayment risk in the student loan
market, and particularly for private student loans held by Prime borrowers. That is an assertion that we will look into
further in the following posts.
Byline:
Derek
Kaknes
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