Prepayment Risk

A workshop raises money online by pre-selling a new bicycle frame. Backers pay today and receive a frame once production finishes; they get no share of the workshop's profits and no interest. Are the backers' claims securities?

1. A.Yes, because the backers advance money and depend on the workshop's efforts to deliver.Wrong. Both facts are true and neither is sufficient, because the element that is missing is the expectation of profit.
2. B.No, because the backers expect a product rather than a financial return on their money.Correct. A prepaid purchase is consumption, and without an expected financial return there is no investment contract.
3. C.Yes, because an offering made over the internet to the general public is a public offering.Wrong. The channel of the offer is irrelevant, and a great deal of ordinary commerce is conducted over the internet.
4. D.No, because a claim is a security only when it is evidenced by a written certificate.Wrong. Nothing in the definition requires a certificate, and most securities today exist only as book entries.

Why: The profit element asks whether the participant seeks capital appreciation or a share of earnings, as opposed to the use or consumption of a good. Backers who prepay for a frame want the frame, so however much they depend on the workshop to build it, the arrangement is a forward purchase rather than an investment. Because one element fails, the test as a whole fails. Restructure the campaign so that backers receive a percentage of every frame sold instead of a frame, and it becomes a securities offering.

An investor owns mortgage-backed securities issued against many different pools of home loans. Interest rates fall and homeowners refinance in large numbers. What happens to her, and does holding many pools help?

1. A.She receives principal later than expected, and holding many pools makes it worse.Wrong. Refinancing accelerates repayment rather than delaying it, so the direction is reversed.
2. B.She receives principal later than expected, and holding many pools reduces the effect.Wrong. The direction is again reversed, and one rate move drives every pool in the portfolio at once.
3. C.She receives principal sooner than expected, and holding many pools removes the problem.Wrong. The direction is right, but a market-wide rate move reaches all the pools simultaneously.
4. D.She receives principal sooner than expected, and holding many pools does not help.Correct. Falling rates trigger refinancing everywhere, returning principal early for reinvestment at lower rates.

Why: Mortgage-backed securities pass through whatever homeowners pay, so when rates fall and borrowers refinance, principal returns sooner than the investor planned. That is prepayment risk, and its sting is that the returned money must be reinvested at the new lower rates. Because the trigger is the general level of interest rates, every pool prepays at once and holding more of them offers no protection. The mirror image is extension risk, where rising rates slow prepayments and leave the investor locked into a below-market yield for longer.