This tutorial is the second of two parts covering fixed income. The subject of asset backed securities (of which mortgage backed securities are technically a large subset) may sound intimidating to some candidates, but this module is actually heavily conceptual. Beyond memorizing a few formulas, there are a lot of definitions and ideas to absorb. […]
Fixed Income Part 2
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 […]
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 […]
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 […]
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 […]
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 […]
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 […]
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 […]
Residential Non-Agency MBS
Non-agency Mortgage-backed Securities are securities issued by private institutions in contract with the agency MBS which is issued by governmental or quasi-governmental agencies. The underlying collateral for non-agency MBS usually consists of mortgages which do not conform to the requirements, such as size, documentation, loan-to-value ratios, etc., of MBS issued by government agencies such as […]
CMBS: Structure and Call Protection
Commercial Mortgage Backed Securities (CMBS) are securities that are collateralized by commercial real estate mortgages on income generating properties. Income generating properties backing CMBS commonly include: apartment buildings, office buildings, industrial properties, hotels, shopping malls, and elderly care facilities. Differences between CMBS and residential MBS Commercial Mortgages are Nonrecourse: Residential mortgages are recourse loans, whereas […]