Mortgage Backed Bonds

Question 0

What is key risk with MBS?

Answer 0

Prepayment risk- prepay all or part of principal value at any time

Note: related to interest rates; people refinance as int rates drop

Question 1

What is a mortgage backed security (MBS)

Answer 1

Bond with cash flows derived from pool of mortgage loans (generally fixed rate, fully amortizing)

Question 2

What is a mortgage pass through security

Answer 2

All mortgage payments including both principal and interest are passed to security holders on pro rata basis

Question 3

What is conditional prepayment rate

Answer 3

Annual rate at which a mortgage pool is expected to be prepaid

Question 4

What is Public Securities Association prepayment benchmark

Answer 4

Assumption about prepayment rate - start at 0.2% annual rate

• increase by 0.2%/month for 30 months
• then constant at 6%

Question 5

How to convert annual rate to single monthly mortality rate (SMM)

Answer 5

SMM = 1 - (1 - CPR)^1/12

Question 6

What three factors influence speed of prepayment rate

Answer 6

Prevailing mortgage rates - spread and path (refinancing burnout)

Housing turnover (inc as int rate fall)

Characteristics of underlying mortgages (seasoning (old = prepaid more) and prop loc)

Question 7

What is contraction risk

Answer 7

Shortening of expected life of the mortgage pool due to falling int rates and higher prepayment

Question 8

What is extension risk

Answer 8

Interest rates increasing and prepayment rates decreasing; bond prices falling; expected timing of CFs extended

Question 9

What is a Collateralized Mortgage Obligation (CMO)

Answer 9

Securities issued against passthrough securities; CFs have been reallocated to diff bond classes called tranches (w/different mixes of ext and cont risk)

Question 10

Describe sequential pay tranches

Answer 10

Bond classes sequentially retired
Short tranche = higher extension risk protection

Longest tranche = higher contraction risk protection

Question 11

Describe accrual bonds

Answer 11

Last tranche to be paid principal; doesn’t get int til others paid off

(Aka Z tranche)

Absorbs extension risk

Question 12

Describe Planned amortization class (PAC) tranches

Answer 12

Amortized based on sinking fund schedule within range of prepayment speeds; two principal repayment schedules forming a collar

Question 13

What are support tranches

Answer 13

Included w/PAC tranches to provide prepayment protection - higher risk

Question 14

Stripped mortgage backed securities (STRIPS)

Answer 14

Only int payments or only principal payments - higher volatility

PO: ^prepayment (v int rates) => ^price
IO: low current rates => ^price

Question 15

What is commercial mortgage backed security (CMBS)

Answer 15

Collateralized by pool of mortgage loans for income producing properties (warehouses, office buildings, apartments)

Question 16

What are two key differences between residential MBS and CMBS

Answer 16

1. MBS repaid by home owners; CMBS repaid by RE investors relying on tenants to provide CF
2. CMBS structured as non-recourse loans; only use collateral vs. borrower

Question 17

Debt-service coverage ratio

Used for CMBS

Answer 17

Debt service

Question 18

Loan to value ratio

Answer 18

Current appraised value

Question 19

How to create loan level call protection

Answer 19

Created by prepayment lockout, defeasance, prepayment penalty points, yield maintenance charges

Question 20

How to create CMBS level call protection

Answer 20

Segregating pools into credit tranches