1.
Fundamentals of Investments 13 C h a p t e r Mortgage-Backed Securities second edition Valuation & Management Charles J. Corrado Bradford D. Jordan McGraw Hill / Irwin Slides by Yee-Tien (Ted) Fu
Traditionally, local banks wrote most home mortgages and then held the mortgages in their portfolios of interest-earning assets.
Then, when market interest rates climbed to near 20% in the early 1980s, bank customers flocked to withdraw funds from their savings deposits to invest in money market funds.
Today, an originator usually sells the mortgage to a mortgage repackager, who accumulates them into mortgage pools.
Financed by mortgage-backed bonds (also called mortgage pass-throughs ), each mortgage pool is set up as a trust fund. A servicing agent collects the mortgage payments and then passes the cash flows through to the bondholders.
The transformation from mortgages to mortgage-backed securities (MBSs) is called mortgage securitization .
The size of the monthly payment is determined by the requirement that the present value of all monthly payments, based on the financing rate specified in the mortgage contract, be equal to the original loan amount.
Fixed-rate mortgage Loan that specifies constant monthly payments at a fixed interest rate over the life of the mortgage.
Mortgage amortization can be described by an amortization schedule , which states the scheduled principal payment, interest payment, and remaining principal owed in any month.
A mortgage borrower has the right to pay off all or part of the mortgage ahead of its amortization schedule. This is similar to the call feature of corporate bonds and is known as mortgage prepayment .
During periods of falling interest rates, mortgage refinancings are an important reason for mortgage prepayments.
Hence, mortgage investors face the risk of a reduced rate of return.
The Government National Mortgage Association (GNMA), or “Ginnie Mae,” is a government agency charged with the mission of promoting liquidity in the secondary market for home mortgages.
GNMA mortgage pools are based on mortgages issued under programs administered by the Federal Housing Administration (FHA), the Veteran’s Administration (VA), and the Farmer’s Home Administration (FmHA).
Like GNMA, both FHLMC and FNMA operate with qualified underwriters who accumulate mortgages into pools financed by an issue of bonds.
However, since FHLMC and FNMA are only GSEs, their fully modified pass-throughs do not carry the same default protection as GNMA fully modified pass-throughs.
The average life of a mortgage in a pool is the average time for a single mortgage in the pool to be paid off, either by prepayment or by making scheduled payments until maturity.
For a pool of 30-year mortgages,
Prepayment Schedule Average Mortgage Life (years) 50 PSA 20.40 100 PSA 14.68 200 PSA 8.87 400 PSA 4.88
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Macaulay Durations for GNMA Mortgage-Backed Bonds
The interest rate risk for a bond is often measured by Macaulay duration, which assumes a fixed schedule of cash flow payments.
However, the schedule of cash flow payments for mortgage-backed bonds is not fixed.
With falling interest rates, prepayments speed up, and vice versa.
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Macaulay Durations for GNMA Mortgage-Backed Bonds
Historical experience indicates that interest rates significantly affect prepayment rates, and that Macaulay duration is a very conservative measure of interest rate risk.
In practice, effective duration is used to calculate predicted prices for mortgage-backed securities based on hypothetical interest rate and prepayment scenarios.
Interest-only strips (IOs) pay only the interest cash flows to investors, while principal-only strips (POs) pay only the principal cash flows to investors.
IO strips and PO strips behave quite differently in response to changes in prepayment rates and interest rates.
Faster prepayments imply lower IO strip values and higher PO strip values, and vice versa.
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Interest-Only and Principal-Only Strips 13 - McGraw Hill / Irwin
All payments of principal will go to the topmost tranche (in alphabetical order), until all the principal in that tranche has been paid off.
All tranches receive proportionate interest payments. These are passed through immediately, except for the Z-tranche. Interest on Z-tranche principal is paid as cash to the topmost tranche in exchange for a transfer of an equal amount of principal, until all the principal in the topmost tranche has been fully paid off.
Protected amortization class (PAC) bonds take priority for scheduled payments of principal. The residual cash flows are paid to PAC support (or companion) bonds .
PAC cash flows are predictable as long as prepayments remain within a specified band.
Specify two PSA prepayment schedules that form the upper and lower prepayment bounds of the PAC bond. These bounds define a PAC collar .
Calculate principal-only (PO) cash flows for the two prepayment schedules specified in .
On a priority basis, at any point in time, PAC bondholders receive payments of principal according to the PSA prepayment schedule with the lower PO cash flow as calculated in .
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Protected Amortization Class Bonds 13 - McGraw Hill / Irwin
The yield to maturity for a mortgage-backed security conditional on an assumed prepayment pattern is called the cash flow yield .
Essentially, cash flow yield is the interest rate that equates the present value of all future cash flows on the mortgage pool to the current price of the pool, assuming a particular prepayment rate.
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