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Extension risk is a concern with Mortgage Backed Securities (MBSs) that funds will be locked up if mortgage holders decide not to pre-pay or refinance their loans. Such securities are often created with the assumption that in a pool of 30-year mortgages, most of them will be prepaid or refinanced before they expire. Thus, investors participating don’t intend to leave their funds in the security for a full 30 years. When circumstances increase the chances of extension risk, it can make such investments more dangerous for participants.
This risk occurs when interest rates start to rise, which often occurs in a good economy. People holding mortgages with a low interest rate clearly have no incentive to refinance, because doing so would probably lead to a higher interest rate. They may also have no particular need or reason to repay, because they don’t need to eradicate a high interest debt quickly. When interest rates trend upwards, extension risk increases, and investment in an MBS can become a less appealing proposition.
Investors in such funds usually expect to see the principal repaid more quickly than the actual terms of the loan. This can occur through prepayment, where debtors increase the size of their monthly payments to reduce the time left on the loan, or through refinancing. When this does not occur, the value of the MBS drops. The coupon value available through sale of the security also falls. An investment trap can result, where people cannot sell their shares without taking a loss, and must instead wait out the term of the MBS.
Investors may have concerns about extension risk if they need highly liquid assets. Mortgage backed securities and other Collateralized Debt Obligations (CDOs) are used in the financial industry to distribute risk and free up assets for further investment activity. When activity in this sector starts to drop, it can create unrest among investors. Some cannot afford to wait it out, and need to liquidate their assets even if this means taking a loss. This in turn can create panic and a domino effect as investors jockey for position in what they sense may be a declining market.
The level of extension risk in an MBS can vary. Analysts may review current market conditions and other factors to provide an estimate. This can change rapidly in response to financial and political trends that might cause interest rates to spike. Savvy and adaptive investors attempt to stay ahead of the market so they don’t get caught with declining investments.