What would happen to an MBS (mortgage-backed security) if hypothetically speaking all the underlying mortgages were fully paid back by the mortgagees (borrowers), much before the maturity date?

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Depends on the structure.

  • In the US, most residential MBS are pass-through, so the MBS is prepaid.
  • In Canada, MBS are (or at least were) mostly packaged into non-passthrough structures, so MBS cash flows follow fixed coupon schedule. There are prepayment penalties which are used to absorb the cash flows.
  • My understanding is that European pfandebriefe markets use a collateral pool, which absorbs prepayments.
  • $\begingroup$ What is a logical reason(s) behind placing a penalty for pre-closure on the borrower? I can only see a greed-fuelled motive from the perspective of the investment bank, so as to keep a mortgage alive for ultimately being able to put it into an MBS. $\endgroup$ – Akshay Prabhakant Feb 14 at 18:04
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    $\begingroup$ If banks absorb prepayment risk, it is extremely difficult for them to duration match their portfolio. The lack of duration matching was a severe issue for banking systems in the 1970s. The US MBS market is somewhat unique in that the bond market absorbs prepayment risk. $\endgroup$ – Brian Romanchuk Feb 14 at 19:27
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    $\begingroup$ And the Danish system is amazingly straightforward— borrowers can buy their own loan back out at the current market price. $\endgroup$ – dismalscience Feb 14 at 20:05

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