What is Conditional Prepayment Rate?

Conditional Prepayment Rate, or CPR for short, is a percentage rate used in the investing world. It pertains to some special types of investments called mortgage-backed securities and collateralized mortgage obligations. Those are fancy names, but all they really mean is bundles of home loans that are packaged and sold to investors.

See, when people take out a mortgage to buy a house, sometimes they end up paying off the loan early before the full 30 years are up. Maybe they sell their home, refinance their mortgage, or just decide to pay extra each month to get rid of the debt sooner. When that happens, it’s called a prepayment.

The CPR is a way to estimate how many of the mortgages in one of those investment bundles will be paid off early in a given year. It looks at the prepayments that happen each month and extends that out to an annual rate.

How CPR is Calculated

To figure out the CPR, the first step is to look at how many prepayments there were in the most recent month compared to all the outstanding mortgages in the pool. Let’s say it’s January, and there were originally 1,000 loans in the mortgage bundle, but 50 have been paid off so far. Of the 950 loans left, ten were repaid in full in January. To get the monthly prepayment rate, divide those 10 January prepayments by the 950 total:

10 / 950 = 0.0105 or about 1.05%

So, for that month, 1.05% of the remaining mortgages were prepaid. To annualize that into a yearly CPR, this formula is used:

CPR = 1 – (1 – Monthly Prepayment Rate)^12

Plugging in the 1.05% monthly rate: CPR = 1 – (1 – 0.0105)^12 CPR = 1 – (0.9895)^12 CPR = 1 – 0.88 CPR = 0.12 or 12%

An annual CPR of 12% means that if prepayments keep happening at the same rate as that most recent month, then after a year 12% of the mortgages that existed at the start of the year will have been prepaid.

Why CPR Matters to MBS and CMO Investors

CPR is super important for investors who buy mortgage-backed securities (MBS) or collateralized mortgage obligations (CMOs). The whole reason they invest in those is to collect a steady stream of payments over many years from all the homeowners paying their mortgages.

But if a bunch of people prepay their mortgages early, then the investors’ stream of income gets cut short. They get their principal back sooner than expected, and don’t collect as much interest. This is called prepayment risk.

On the flip side, prepayments can sometimes benefit investors too. If market interest rates have fallen since they first bought the MBS or CMO, getting their principal back early lets them reinvest it at the new, higher rates and earn more.

Either way, CPR gives investors a way to estimate how many prepayments to expect. A higher CPR means more loans in the pool will likely be paid off ahead of schedule. MBS and CMO prices and yields depend a lot on what CPR is assumed.

Factors that Affect CPR

A lot of things can impact how many people choose to prepay their mortgages early. Some of the big ones are:

1. Interest Rates

When market interest rates fall, it often makes sense for homeowners to refinance their existing mortgages at the new lower rate. Refinancing pays off the original loan early. So in a falling interest rate environment, CPRs will usually be higher.

2. Home Prices

If home values in an area are rising fast, more people may sell their appreciated houses. Selling leads to prepayment of the mortgage. Strong housing markets tend to increase prepayment rates.

3. Seasonality

For various reasons, home sales and refinancing activity often picks up in the spring and summer months. So CPRs frequently show a seasonal pattern of being higher in certain times of the year.

4. Burnout

The mortgages most likely to be prepaid are the ones with the most incentive, like high interest rates. Once those have largely been refinanced, the remaining loans in the pool have lower prepayment risk. This “burnout” can cause CPRs to decline over time for a given MBS or CMO.

5. Seasoning

It’s been observed that mortgages usually have low CPRs in the first year, then the rate climbs for a few years before stabilizing. Mortgages that are more seasoned or mature have different prepayment probabilities than newer ones.

Limitations of CPR

CPR can be a useful metric for MBS and CMO investors, but it’s far from perfect. It’s based on looking at just the most recent month of prepayments. If that month was unusually high or low compared to the long-term trend, the calculated CPR will be distorted.

CPR also ignores the age of the mortgages, even though seasoning is a known factor in prepayment rates. A pool of 10-year-old mortgages will typically have a much different prepayment profile than one full of brand new loans.

In addition, CPR is a single annual average rate, but in reality prepayments can be quite lumpy and irregular month-to-month. And it assumes prepayments will stay the same for the next year, but as factors like interest rates and home prices change, behavior can shift quickly.

So CPR is a quick and dirty way to estimate prepayment risk, but investors often rely on more sophisticated models as well. These models try to take into account factors like burnout, seasoning, geographical mix, current and expected future interest rates, and more. Comparing CPR to the outputs of these models can give a more complete picture.

Other Prepayment Metrics

CPR isn’t the only game in town when it comes to measuring prepayments. Some other common metrics are:

Single Monthly Mortality (SMM)

This is basically just the monthly prepayment rate that’s used to calculate CPR. But some investors look directly at SMM itself.

Public Securities Association (PSA) Prepayment Model

PSA is a model that estimates prepayment rates based on the age or seasoning of the mortgages. It assumes very low prepayments initially, ramping up quickly to 6% CPR after 30 months. Instead of an absolute CPR, securities are often assigned a PSA speed, like 200 PSA or 50 PSA. This just means a CPR that’s some percentage of the baseline PSA model prediction.

The Bottom Line on CPR

Conditional Prepayment Rate (CPR) is a key measure of prepayment risk for mortgage-backed securities and collateralized mortgage obligations. It looks at recent prepayment activity and extrapolates it into an annual rate.

Many factors can influence prepayment rates, including prevailing interest rates, trends in home prices, seasonality, and the age of the mortgages. CPR has some limitations in capturing all these complexities and can give misleading signals, so investors often combine it with other prepayment models.

Though CPR seems like a niche concern, it has big implications. MBS and CMOs are huge asset classes, and prepayment risk affects everything from their pricing to their yields to their weighted average life. Even small changes in CPR assumptions can swing valuations substantially. So it’s an important concept to grasp for anyone dealing with mortgage-related investments.