Module 65: Mortgage backed Securities Flashcards
(31 cards)
What is prepayment risk?
The risk that the some or all of a mortgage-backed security’s principal is repaid at a different speed than contractually agreed
What are the two types of prepayment risk?
Extension Risk: Prepayments are made longer than originally expected
Contraction risk: Prepayments are made faster than originally expected
What’s the relationship between low interest rates and prepayment risk?
- If interest rates are down then levels of prepayments (payments ahead of schedule) are typically higher than forecasted (true for fixed-rate mortgage loans)
- If interest rate drops, then borrowers with fixed rate mortgages refinance at lower rates, especially true if there are little/no penalties to prepayments.
- So the maturity of the MBS will be shorter than expected at the time of purpose.
Why is contraction prepayment unfavourable to the MBS investor
- They must reinvest the proceeds at lower rates
- The prepayment option is held by the borrower and thus reduces the value appreciation protential of MBS
What’s the relationship between higher interest rates and prepayment risk?
Borrowers would be less likely to refinance, and people are less likely to live houses
Maturity of MBSs are likely to be longer and extension risk would increase.
Why is extension prepayment unfavourable to the MBS investor
Can’t reinvest the money at the high interest rates as the money isnt coming
Fixed cash flows at a higher rate enviroments (so lowers the value of the cash flows that you will reiceve) as its a larger discount factor.
What are the mechanism for managing prepayment risk
Time Tranching
What is Time Tranching?
Principal payments go to the holders of the first tranch, until principal of that tranch is repaid
Issuing bonds belonging to different tranches with different expected maturities
What’s a residentual mortgage loan?
It’s a loan on a specific property
Lender has first lien -> Has the right to sieze the property and sell it and use the proceeds to settle the borrowers obligation.
What is a loan to value ratio?
It’s the percentage of the value of rhe colleral real estate that is loaned to the borrower
What is Debt it income ratio?
This measures the monthly debt payments of the individual as a percentage of their monthly pretax income
Calculation: N = Total months of repayment, PV = amount borrowed, FV = 0, I/Y = interest rate / 12, then compute constant monthly payment to service mortgage
Then monthly payment payment / monthly pre tax income
What’s the difference between Prime Loans and Subprime
Prime Loans: Made to high quality borrowers. with LTV, and low DTI
Subprime Loans: Made to lower quality borrowers, with higher DTI, higher LTVs, Loans are secured by 2nd lien
What are the different types of Residential Mortgage Back Securitiess
Agency RMBS: guaranteed by the governement or a government sponsored enterprise, and issued by them, and carries the full faith credit of the government if a government RMBS, but government sponsored ones are backed by the GSE itself
Non-Agency RMBS: Issued by private entities such as bank and have no gov or GSE guarantee
What are prepayment mortgage contingency features?
Prepayment penalities: Borrower has the option to prepay their loan, which creates cash flow uncertainty, so they implement penalties for early prepayment that compensates the lender for the interest rate loan.
Recourse: In the case of default, If the proceeds from the sale is not sufficient, then the lender still has a claim against the borrower for shortfall
Non-Recourse: In case of default, and insufficient proceeds from sale, the lender has no recourse
What are underwater mortgages?
- When the property value falls below the outstanding mortgage balance
- Borrowers are likely to default on purpose so they’re not paying as much
What’s a mortgagre pass through security?
Represrents a claim on the cash flow from apool of mortgages- net of administration fees
What is the weighted average maturity?
It’s the weighted average of the final maturities of all the mortgages in the pool, weighted by each mortgages outstanding principa;l balance as a proportion of overal outstanding principal.
calculation = maturity 1 (balance 1 / overall) + maturity 2 (balance 2 / overall)….
What is the weighted average coupon?
It’s the weighed average of interest rates of all the mortgages in the pool
Calculation: calculation = IR 1 (balance 1 / overall) + IR 2 (balance 2 / overall)….
What are collateralised mortgage obligations
Securities that are collateralised by pass thorugh MBSs and pools of mortgages, each CMO has multiple bond classes that have different exposures to prepayment risk
What are types of CMO structures?
Sequential Pay CMO: principal payments for the collateral flow to tranches in a prespecified order.
Z-Tranche: A CMO tranch that recieves no interest during a specific period, but recieves interest as extra prinicipal
**Principal only: **Pay only principal and thus they benefit from decreased Interest rates as prepayments increase.
Interest only: Pay only interest rates, so if interst rates go down, prepayment goes down as you only make interest when there’s principal outstanding
**Floating rate tranches: **Interest recieved is linked to a market reference rate (may be subject to a cap/floor) - coupons may be inveresly related
Residual Tranche: Pays out residual cash flows after all different tranches have been paid
What is a Planned amortization class (PAC) tranches and support tranche
If prepayments rates are within a predetermined range (as expected), investors holding this tranche would recieve principal payments according to a fixed schedule, over a specified period.
Investors holding support tranches, then if there’s contraction risk they will recieve the early money, yet if its flowing slower, then the support tranches don’t get paid
What are Commercial Mortgage Backed Securities
Are backed by pools of commercial mortgages on income produce real estate.
What is the repayment sources?
Usually typically income from the property
