What Is Burnout
Burnout describes a period of time over which the prepayment rates of a mortgage-backed security (MBS) slow despite lowering interest rates. When interest rates drop, the mortgage holders underlying the MBS have an incentive to refinance. When they fail to refinance, this is attributed to burnout. The assumption is that the majority of borrowers refinanced earlier in the interest rate drop cycle and the remainder are unable to due to some other factor, like a lack of equity in the property or a reduction in their personal creditworthiness. Burnout is used in many risk models that help to price and evaluate mortgage-backed securities. Burnout is also written as "burn-out" and referred to as "burnout phenomenon" or "refinancing burnout."
Breaking Down Burnout
Burnout is closely tied to the interest rate environment. If interest rates take a fall in any particular month, it usually results in a higher single monthly mortality, basically a larger overall principal repayment on the MBS. Prepayment is a negative for the MBS holder because they get their money back faster than planned without interest. This reduces the interest generated over the whole MBS and also saddles the investor with money to reinvest in a low interest rate environment. So MBS investors tend to look hard at new issues and their existing portfolios when interest rates dip. It gets interesting, however, when interest rates weaken for multiple months. Instead of continuing to see increasing prepayment on the underlying loans, the single monthly mortality rate will level off and even fall back to the historical average. That return to average is burnout and it can be worked into risk and pricing models using historical and/or statistical data.
Factors That Influence Refinancing Burnout
With any mortgage finalized prior to an interest rate drop, there will be a point at which it makes more sense to refinance at the lower rate than to hold on to the existing loan. That said, there are a number of factors that affect the ability of the borrower to refinance, consequently influencing burnout. There will be fixed costs to refinancing that vary state to state and according to the terms of each loan. If the fixed costs of refinancing are high, people are more reluctant to refinance unless the interest savings is even greater. The data also shows that borrowers with a higher credit rating are quick to refinance. That is, they make the decision to refinance early in the decline in interest rates, as soon as it makes economic sense, rather than waiting. This may be simply because they can, while others may not be able to take on the additional refinancing costs, as their savings, built-up equity and overall debt burden are not as good as the high credit rating group. So once the higher credit rating group has refinanced, chances are good that refinancing burnout sets in.
An MBS will go through interest rate cycles several times over its term, so they are more attractive after burnout has occurred as it means that the prepayment risk in the immediate future has dropped.