Explanation

This question tests understanding of prepayment risks in mortgage-backed securities (MBS), specifically mortgage pass-through securities.

Key Concepts:

1. Average Life: The weighted average time until principal is returned to investors in a mortgage-backed security.

2. Prepayment Risks:

   • Contraction Risk: The risk that prepayments will occur faster than expected, shortening the average life of the security. This typically happens when interest rates fall, and homeowners refinance their mortgages.
   • Extension Risk: The risk that prepayments will occur slower than expected, lengthening the average life of the security. This typically happens when interest rates rise, and homeowners are less likely to refinance.
   • Balloon Risk: Typically refers to the risk associated with balloon mortgages where a large payment is due at maturity.

Analysis:

• The average life decreased from 5 years to 2 years over 6 months
• This represents a significant shortening of the security's duration
• A decrease in average life indicates faster-than-expected prepayments
• Faster prepayments occur when interest rates fall, allowing homeowners to refinance at lower rates

Why C is Correct: The shortening of average life from 5 years to 2 years indicates contraction risk - investors received their principal back faster than expected, which is problematic for investors who were counting on longer-term cash flows, especially if they need to reinvest at lower prevailing interest rates.

Why Other Options are Incorrect:

• A (Balloon Risk): Not applicable here as this refers to a specific type of mortgage structure, not prepayment behavior.
• B (Extension Risk): This would be the opposite scenario - if average life increased rather than decreased.

Real-World Context: This scenario is typical when interest rates decline significantly. Mortgage pass-through security investors face reinvestment risk when they receive principal earlier than expected and must reinvest at lower prevailing rates.