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Collateralized Mortgage Obligations and Prepayment Risk

Collateralized Mortgage Obligations are a type of Special Purpose Vehicle (SPV), which is separate from the entity that created it. The CMO is created to issue securities to different investors based on a pool of mortgages owned by the SPV. All the mortgages put together are called a pool. In a CMO the investors buy

Pay-through Structures: Prepayment Tranching vs. Credit Tranching

Asset-backed securities can be issued as pass-through or pay-through securities. ABS Pass-through Structure: In a pass-through structure, the cash flows generated by the asset pool are passed through to investors, less a servicing fee, on a pro-rata basis (this is the same general structure as that of the mortgage pass through securities previously discussed). ABS

Stripped MBS – Interest Only (IO) and Principal Only (PO)

Mortgage backed securities can be stripped into principal only (PO) strips and interest only (IO) strips. The principal component of the MBS payment is used to pay down the PO strip MBS, while the interest component of the payment is used to pay the IO strip MBS. The bonds of stripped MBS therefore do not

Collateralized Mortgage Obligations (CMO) and CMO Tranches

With mortgage pass-through securities, investors share equally in interest coupon and principal cash flows and therefore all assume equal prepayment, extension, and contraction risk. CMO structures will take one or more pass-through securities, divide up the cash flows, and then prioritize the cash flows from the collateral to different bond classes called tranches. These tranches

MBS Weighted Average Life

Because mortgages are more likely to be prepaid rather than paid off on schedule, mortgage maturity (date the final mortgage payment is due) is not a good measure for the time length of a mortgage. A more suitable measure is the Weighted Average Life (WAL). It is the weighted average time for principal repayment, that

PSA Prepayment Benchmark

PSA Standard Benchmark The Public Securities Association’s (now known as the Bond Market Association) established convention for expressing prepayments on a mortgage pass-through. The PSA Benchmark is expressed as a series of monthly prepayment rates. It’s also referred to as a prepayment model suggesting that it can be used to estimate prepayment rates. It assumes

Single Monthly Mortality (SMM) & Conditional Prepayment Rate (CPR)

Conditional Prepayment Rate (CPR) CPR is the annualized percentage of the existing mortgage pool that is expected to be prepaid in a year. This assumes a constant rate for prepayment, i.e., after every coupon, a constant percentage of the mortgages will be prepaid. This is also called the Constant Mortgage Mortality (CMM). For example, if

Cash Flows and Prepayment Risk

Prepayment risk is the risk that a borrower will repay the mortgage before its due date. Mortgages can usually be prepaid at any time without penalty. Two Types of Prepayment Risk Contraction Risk: This is the risk that the investor (holder of the fixed income security) is forced to re-invest for a lower return following

Mortgage Pass-through Securities: Characteristics and Risks

Mortgage Pass-through Security: shares in a pool of mortgages sold by a financial institution or government agency, where mortgage payments less fees are passed through to the security investors. A mortgage pass-through security is a type of MBS. Following issuance, pass-throughs can be resold by investors on the secondary market. Pass-through Rate = Mortgage Rate

Mortgage Cash Flow Characteristics

Simply put, a mortgage is a debt instrument that is backed by real estate as collateral. Fully Amortized Mortgage Loan: Borrower makes an equal monthly payment that includes an interest component and a principal repayment component. In the early years of the repayment schedule, interest makes the largest share of the monthly payment, as principal