This

**preview**shows pages 1-3. to view the full**12 pages of the document.**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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