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Lecture 9

ADM3351 Lecture 9: Ch11


Department
Administration
Course Code
ADM 3351
Professor
Chen Guo
Lecture
9

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CHAPTER 11
MORTGAGE PASS-THROUGH SECURITIES
CHAPTER SUMMARY
The pass-through mortgage securities are the subject of this chapter. A
mortgage pass-through security, or simply a pass-through, is created when
one or more mortgage holders form a collection (pool) of mortgages and sell
shares or participation certificates in the pool. From the pass-through, two
further derivative mortgage-backed securities are created: collateralized
mortgage obligations and stripped mortgage-backed securities, which are
discussed in Chapter 12.
CASH FLOW CHARACTERISTICS
The cash flow of a mortgage pass-through security depends on the cash flow
of the underlying mortgages. Payments are made to security holders each
month. The monthly cash flow for a pass-through is less than the monthly
cash flow of the underlying mortgages by an amount equal to servicing and
other fees. The other fees are those charged by the issuer or guarantor of the
pass-through for guaranteeing the issue. The coupon rate on a pass-through
is called the pass-through coupon rate.
The monthly mortgage payment is due from each mortgagor on the first day
of each month, but there is a delay in passing through the corresponding
monthly cash flow to the security holders. The length of the delay varies by
the type of pass-through security.
WAC AND WAM
When describing a pass through security, a weighted average coupon rate
and a weighted-average maturity are determined. A weighted-average
coupon rate (WAC) is found by weighting the mortgage rate of each
mortgage loan in the pool by the amount of the mortgage outstanding. A
weighted average maturity (WAM) is found by weighting the remaining
number of months to maturity for each mortgage loan in the pool by the
amount of the mortgage outstanding.
Conditional Prepayment Rate (CPR)
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One benchmark for projecting prepayments and the cash flow of a pass-
through requires assuming that some fraction of the remaining principal in
the pool is prepaid each month for the remaining term of the mortgage. The
prepayment rate assumed for a pool, called the conditional prepayment
rate (CPR), is based on the characteristics of the pool (including its
historical prepayment experience) and the current and expected future
economic environment. It is referred to as a conditional rate because it is
conditional on the remaining mortgage balance.
PSA Prepayment Benchmark
The Public Securities Association (PSA) prepayment benchmark is
expressed as a monthly series of annual prepayment rates. The PSA
benchmark assumes that prepayment rates are low for newly originated
mortgages and then will speed up as the mortgages become seasoned.
The CPR of 100(%) PSA:
t = number of month since formation of the mortgage pool.
If
30t
: the CPR of 100 PSA = 6% (t/30)
If
30t
: the CPR of 100 PSA = 6%.
Other CPR:
Example, the CPR of 200 PSA = 2×(CPR of 100 PSA)
the CPR of 275 PSA = 2.75×(CPR of 100 PSA).
The average time to move is implied by various PSA assumptions. For
example, 100 PSA means that for newly originated mortgages, homeowners
prepay on average after 17.4 years. If an investor believes that housing
turnover is about eight years (i.e., homeowners prepay on average after eight
years), then 275 PSA is the appropriate speed for newly originated
mortgages.
We can construct a monthly cash flow for a hypothetical pass-through given
a PSA assumption. The cash flow can be broken down into three
components: interest (based on the pass-through rate), the regularly
scheduled principal repayment, and prepayments.
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The CPR is an annual prepayment rate. To estimate monthly prepayments,
the CPR must be converted into a monthly prepayment rate, commonly
referred to as the single-monthly mortality rate (SMM). A formula can be
used to determine the SMM for a given CPR:
SMM = 1 – (1 – CPR)1/12 (11.1)
An SMM of w% means that approximately w% of the remaining mortgage
balance at the beginning of the month, less the scheduled principal payment,
will prepay that month.
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