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CFA Level II Alts & Fixed Income > Reading 48 - Mortgage-Backed Sector of the Bond Market > Flashcards

Reading 48 - Mortgage-Backed Sector of the Bond Market Flashcards

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1
Q

What are the 4 important features of fixed rate, level payment, fully amortized mortgage loans?

A
  1. The amount of the principal payment increases as time passes
  2. The amount of interest decreases as time passes
  3. The servicing fee also declines as time passes
  4. The ability of the borrower to prepay results in prepayment risk
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2
Q

What is scheduled amortization?

A

the incremental reduction of outstanding principal.

***Think an amortization schedule

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3
Q

What is servicing fee?

A

The collection of payments and all of the other administrative activities associated with mortgage loans

*** are usually built into the mortgage rate**

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4
Q

What are prepayments?

A

Payments in excess of the required monthly payment.

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5
Q

What are curtailments?

A

Prepayments for less than the outstanding principal balance.

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6
Q

What is prepayment risk?

A

The fact that prepayments of curtailments will reduce the amount of interest the lender receives over the life of the loan.

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7
Q

What is a mortgage passthrough security?

A

represents a claim against a pool of mortgages.

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8
Q

What is securitization?

A

since passthrough securities may be traded in the secondary markets, they effectively convert illiquid mortgages into liquid securities… **This is securitization***

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9
Q

What is the most important characteristic of passthrough securities?

A

Prepayment risk

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10
Q

What are the two industry conventions that have been adopted as benchmarks for prepayment rates?

A
  1. Conditional prepayment risk (CPR)
  2. Public Securities Association (PSA)
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11
Q

What is the CPR?

A

Conditional Prepayment Risk

The annual rate at which a mortgage pool is expected to be prepaid.

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12
Q

We can convert the CPR Into a monthly prepayment rate called the single monthly mortality rate.

How do you calculate the SMM and what does an SMM imply?

A

An SMM of 10% implies that 10% of a pool’s beginning of month outstanding balance, less scheduled payments, will be prepaid during the month

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13
Q

Define the PSA prepayment benchmark…

A

it assumes that the monthly prepayment rate for a mortgage pool increases as it ages, or becomes seasoned.

The PSA assumes a 0.2% annual rate and increases by 0.2% each month for the first 30 months. .. After 30 months it is capped at 6%.

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14
Q

Compute the CPR and SMM for the 5th month, assuming 100 PSA and 150 PSA…

A

Assuming 100 PSA:

CPR(month 5) = 5 * 0.2% = 1%

100 PSA = 1 * 0.01 = 0.01

SMM = 1-(1-0.01)1/12

Assuming 150 PSA:

CPR(month 5) = 5 *0.2 = 1%

150 PSA = 1.5 *0.01 = 0.015

SMM = 1-(1-0.015)1/12

=0.006476

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15
Q

How can we estimate the prepayment amount for any month m?

A

= SMMm*(mortgage balance at beginning of month m - scheduled principal payment for month m)

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16
Q

What are the 3 main factors that have been shown to affect prepayments?

A
  1. Prevailing mortgage rates
  2. Housing turnover
  3. Characteristics of the underlying mortgages
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17
Q

What are the two characteristics that affect the level of prepayments?

A
  1. Seasoning (ie age of loan)
  2. Property Location
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18
Q

What are the two types of prepayment risks?

A
  1. Contraction risk
  2. Extension risk
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19
Q

What is Contraction Risk?

A

The shortening of the expected life of the mortgage pool due to falling interest rates and higher prepayent rates

20
Q

What are the two undesirable consequences for passthrough investors when interest rates decline?

A
  1. MBS exhibit negative convexity as rates decline due to the embedded call option granting the mortgage borrower the right to prepay
  2. Reinvestment rate risk - investors in MBSs are forced to reinvest at relatively lower rates.
21
Q

What is Extension risk?

A

when interest rates increase and prepayment rates fall.

**This is unpreferable for mortgage investors because they would prefer to recapture their principal as soon as possible and reinvest at the current higher rates.

22
Q

Define what a collateralized mortgage obligation (CMO) is…..

A

It is when cash flows generated by a mortgage are pooled into different risk packages

23
Q

What is a sequential pay CMO?

A

Each class of bonds is retired sequentially.

Each tranche’s holder receives interest payments as long as the tranche’s principal amount has not been completely paid off. The senior tranche receives all initial principal payments until it is completely paid off, after which the next most senior tranche receives all the principle payments, and so on.

24
Q

What is the principal pay down window in regards to CMOs?

A

The time period between the first and last principal payments on a CMO tranche.

25
Q

What is a Z-tranche (accrual tranche) ?

A

It is the last tranche to receive principal and it does not receive current interest until the other tranches have been paid off.

**Absords most of the extension risk in a sequential-pay structure.

26
Q

Describe a planned amortization class (PAC) CMO……..

Describe their contraction and extension risk…..

A

Is the most common type of CMO.

Is a tranche that is amortized based on a sinking fund schedule that is established within a range of prepayment speeds.

***Have lower contraction and extension risk than their support tranches

27
Q

What is a PAC window?

A

The time period over which principal is expected to be paid of a PAC tranche.

28
Q

What is a support tranche?

A

Are included in a structure with PAC tranches specifically to provide prepayment protection for the PAC tranches.

29
Q

What is a broken or busted PAC?

A

When excesss prepayments occur, the support tranches will eventually be paid off, and the principal will then go to the PAC holders.

30
Q

What is a stripped mortgage-backed security?

A

Principal and interest are not allocated on a pro rata basis.

The unequal allocation of principal and interest results in a price/yield relationship for the stripped securities which are much different from the underlying passthorough.

31
Q

What are the 2 most common types of stripped MBSs?

A
  1. principal-only (PO) strips
  2. interest-only (IO) strips
32
Q

Describe principal-only (PO) strips…..

A

are a class of securities that receive only the principal payment portion of each mortgage payment

**they are sold a considerable discount to par***

**Investmentment performance is extremely sensitive to prepayment risk

33
Q

Describe interest-only (IO) strips….

A

a class of securities that receives only the interest component of each payment.

IO strip cash flow starts out big and gets smaller over time

34
Q

Do IO investors benefit when prepayment are low or high?

A

Low

35
Q

What is the main difference between agency and nonagency MBSs?

A

Nonagency are those that usually fail to meet the agency’s underwriting standards.

They are referred to as nonconforming mortgage loans.

36
Q

Why are nonagency CMOs referred to as whole-loan CMOs?

A

b/c unsecuritized loans are called whole loans.

***The collateral behind nonagency CMOs is a pool of loans rather than passthrough securities.

37
Q

What is a nonrecourse loan?

A

When the lender can only look to the collateral as a means to repay a delinquent loan if the cash flows from the property are insufficient.

38
Q

What are the 2 key ratios used in analyzing CMBSs structures?

A
  1. Debt-to-service coverage ratio
  2. Loan-to-value ratio
39
Q

What does a DSCR ratio below 1.0 indicate?

A

That the borrower is not capable of making the debt payments and is likely to default.

***Higher is better for this ratio from the perspective of the lender and the MBS investor.

40
Q

Is a higher or lower LTV ratio better from the perspective of the lender and the MBS investor?

A

Lower is better

41
Q

What are the two ways that a CMBS provides call protection?

A
  1. Loan-level call protection provided by the structure of the individual mortgage
  2. Call protection provided by the CMBS structure.
42
Q

What are the ways of creating loan-level call protection within a CMBS?

A
  1. Prepayment lock out
  2. Defeasance
  3. Prepayment penalty points
  4. Yield maintenance charges
43
Q

What is defeasance in regards to loan-level call protection within a CMBS structure?

A

if the borrower insists on making payments on the mortgage loan it can be defeased...

This means the loan proceeds are received by the loan servicer and invested in U.S. Treasury securities, essentially creating cash collateral against the loan.

44
Q

What are prepayment penalty points in regards to loan-level call protection within a CMBS structure?

A

This is a penalty fee if the borrower prepays the loan.

It is usually much higher in the early yrs. Often the fee is quoted a 5-4-3-2-1, means 5% fee in yr one, 4% in yr 2 …etc.

45
Q

What are yield maintenance charges in regards to loan-level call protection within a CMBS structure?

A

The borrower is charged the amount of interest lost by the lender if the loan is prepaid.

CFA Level II Alts & Fixed Income (7 decks)

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