What Is Burnout?
Burnout describes a period of time during which the prepayment rates of mortgage-backed securities (MBS) slow, despite falling interest rates. When the cost of borrowing drops, the mortgage holders underlying the MBS have an incentive to refinance. If they fail to take advantage, it is attributed to burnout.
Burnout is also written as "burn-out" and referred to as "burnout phenomenon" or "refinancing burnout."
- Burnout describes a period of time during which the prepayment rates of mortgage-backed securities (MBS) slow, despite falling interest rates.
- When the cost of borrowing drops, the mortgage holders underlying the MBS have an incentive to refinance. If they don't, it is attributed to burnout.
- Burnouts occur when the majority of borrowers refinance earlier in the interest rate drop cycle and the remainder are unable to follow suit, perhaps due to a lack of equity in the property or a reduction in their personal creditworthiness.
Burnout is closely tied to the interest rate environment. If interest rates take a fall in any particular month, it usually leads to a higher single monthly mortality—in other words, a larger overall principal repayment on the MBS.
Holders of MBS, investments made up of a bundle of home loans bought from the banks that issued them, do not want people to settle their mortgage debts before they are due. Yes, they get their money back faster than planned from the quick repayment of the mortgage. However, this also results in them missing out on collecting all the interest, the monthly payments charged to borrow money to buy a home, they expected to receive as part of the package. Suddenly, a chunk of income generated from the MBS disappears and the investor is saddled with money to reinvest in a low interest rate environment.
MBS investors often seek to navigate these risks by looking hard at new issues and their existing portfolios when interest rates dip. Prepayment trends can shift, though, when interest rates weaken for multiple months. Against this particular backdrop, the single monthly mortality rate may level off and even fall back to the historical average.
How does this happen? 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, such a lack of equity in the property or a reduction in their personal creditworthiness. That return to average is burnout and it can be worked into risk and pricing models using historical and/or statistical data.
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.
Data shows that borrowers with a higher credit rating are quick to refinance. In other words, they make the decision to revise the payment schedule and terms of a previous credit agreement early in the decline in interest rates, taking action as soon as it makes economic sense, rather than waiting.
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. That means that once the higher credit rating group has refinanced, there is a decent chance that a refinancing burnout will take hold.
An MBS will go through interest rate cycles several times over its term. These asset back securities (ABS) are considered more attractive after burnout has occurred as it means that the prepayment risk in the immediate future has dropped.