Mortgage Backed Bonds Flashcards
What is key risk with MBS?
Prepayment risk- prepay all or part of principal value at any time
Note: related to interest rates; people refinance as int rates drop
What is a mortgage backed security (MBS)
Bond with cash flows derived from pool of mortgage loans (generally fixed rate, fully amortizing)
What is a mortgage pass through security
All mortgage payments including both principal and interest are passed to security holders on pro rata basis
What is conditional prepayment rate
Annual rate at which a mortgage pool is expected to be prepaid
What is Public Securities Association prepayment benchmark
Assumption about prepayment rate - start at 0.2% annual rate
- increase by 0.2%/month for 30 months
- then constant at 6%
How to convert annual rate to single monthly mortality rate (SMM)
SMM = 1 - (1 - CPR)^1/12
What three factors influence speed of prepayment rate
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)
What is contraction risk
Shortening of expected life of the mortgage pool due to falling int rates and higher prepayment
What is extension risk
Interest rates increasing and prepayment rates decreasing; bond prices falling; expected timing of CFs extended
What is a Collateralized Mortgage Obligation (CMO)
Securities issued against passthrough securities; CFs have been reallocated to diff bond classes called tranches (w/different mixes of ext and cont risk)
Describe sequential pay tranches
Bond classes sequentially retired
Short tranche = higher extension risk protection
Longest tranche = higher contraction risk protection
Describe accrual bonds
Last tranche to be paid principal; doesn’t get int til others paid off
(Aka Z tranche)
Absorbs extension risk
Describe Planned amortization class (PAC) tranches
Amortized based on sinking fund schedule within range of prepayment speeds; two principal repayment schedules forming a collar
What are support tranches
Included w/PAC tranches to provide prepayment protection - higher risk
Stripped mortgage backed securities (STRIPS)
Only int payments or only principal payments - higher volatility
PO: ^prepayment (v int rates) => ^price
IO: low current rates => ^price
What is commercial mortgage backed security (CMBS)
Collateralized by pool of mortgage loans for income producing properties (warehouses, office buildings, apartments)
What are two key differences between residential MBS and CMBS
- MBS repaid by home owners; CMBS repaid by RE investors relying on tenants to provide CF
- CMBS structured as non-recourse loans; only use collateral vs. borrower
Debt-service coverage ratio
Used for CMBS
Debt service
Loan to value ratio
Current appraised value
How to create loan level call protection
Created by prepayment lockout, defeasance, prepayment penalty points, yield maintenance charges
How to create CMBS level call protection
Segregating pools into credit tranches
