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Mortgage Pass-Through Securities. Fabozzi—Chapter 11. Introduction – pg 244. What is a mortgage pass-through security? A security comprised of a pool (portfolio) of residential mortgages.

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Mortgage pass through securities

Mortgage Pass-Through Securities

Fabozzi—Chapter 11


Introduction pg 244
Introduction – pg 244

  • What is a mortgage pass-through security?

    • A security comprised of a pool (portfolio) of residential mortgages.

    • All monthly interest and principal payments made by homeowners are passed through to the security holders (less fees).

  • Not all of the mortgages in the pool have the same maturity or interest rate. So pass-throughs use:

    • Weighted-Average Coupon Rate (WAC).

    • Weighted-Average Maturity (WAM).

    • WAC and WAM weight the coupon or maturity by outstanding amount of mortgage.


  • Diagram of a pass through
    Diagram Of A Pass-Through

    Pooled Monthly Cash Flow:

    -Pooled Interest-Pooled Principal-Pooled Prepays

    Each Homeowner Pays:-Interest-Scheduled principal-Prepayments

    Pass-through coupon paid to investors


    Agency pass throughs
    Agency Pass-Throughs

    • Pass-throughs guaranteed by government-sponsored agencies. There are three types:

      • Ginnie Mae (Government National Mortgage Association): Backed by full faith and credit of US Government.

      • Freddie Mac (Federal Home Loan Mortgage Corporation): Not guaranteed by US Government. But most consider it very low risk.

      • Fannie Mae (Federal National Mortgage Association): Not guaranteed by US Government, but considered low risk.

  • Types of guarantees:

    • Fully modified pass-throughs: guarantee timely payment of interest and principal even if mortgager fails to pay.

    • Modified pass-throughs: both interest and principal and interest are guaranteed, but only interest is guaranteed to be timely. Principal payment occurs when collected, but no later than a specified date.


  • Nonagency pass throughs
    Nonagency Pass-Throughs*

    • Issued by commercial banks, thrifts, and private conduits:

      • They have no guarantees by the U.S. Government.

      • Success of this market has been driven by credit enhancements.

  • External Credit Enhancements: Third-party guarantees losses up to specific level (usually 10% loss). (See Page 247)

    • Bond insurance – Guarantees interest and principal when due.

    • Pool insurance** – Covers losses from defaults and foreclosures.

  • Internal Credit Enhancements:

    • Reserve funds – cash reserve acct for payment of interest and principal.

      • Excess Spread Accounts*** – gradually increase as pass through seasons

    • Overcollateralization – Principal amount of mortgages paying into pool exceeds principal amount issued by pool.

    • Senior/Subordinate structure – by far most common enhancement.

      • See next slide for example on Senior/Subordinate structure


  • Senior subordinate structure
    Senior/Subordinate Structure

    • Securities sold against the pool of mortgages are classified according senior/subordinate credit:

      • Subordinate class absorbs first losses on underlying mortgages.

  • Example: $100 million security is divided into two classes:

    • $90 million senior class and $10 million subordinate class.

    • The subordinate class will absorb all losses up to $10 million.

    • Senior class experiences no losses until losses exceed $10 million.

    • Obviously subordinate bondholders will require a much higher yield than senior bondholders.


  • Valuing a mortgage pass through
    Valuing a Mortgage Pass-Through

    • To value a pass-through it’s necessary to project its cash flow. This can be difficult:

      • Interest payment – easy

      • Scheduled principal payment – easy

      • Prepayment – difficult

  • To value a pass-through assumptions must be made about the prepayment rate in the underlying mortgage pool:

    • The prepayment rate assumed is called the prepayment speed or speed.

    • The yield calculated based on the projected cash flow is called a cash flow yield.


  • How to estimate cash flow
    How To Estimate Cash Flow

    • *In the early days the market used a naïve approach:

      • Assumed no prepayments during the first 12 years.

      • After 12 years, all mortgages were assumed to prepay.

  • *This was replaced by FHA Prepayment Experience:

    • Prepayment rates were derived from historical data from the FHA (Federal Housing Administration).

    • FHA experience is not necessarily accurate for all mortgage pools.

    • This is no longer used.

  • Another benchmark for prepayment is called the Conditional Prepayment Rate (CPR):

    • CPR is proportion of the remaining principal in pool that will be repaid for the remaining term of the mortgage.

    • CPR is an annual rate based on the characteristics of the mortgage pool and future expected economic environment.


  • Prepayments using cpr
    Prepayments Using CPR

    • Since CPR is an annual rate, it has to be converted to a monthly rate, called the single-monthly mortality rate (SMM):

      • Formula 11.1

    • An SMM of x% means:

      • Approximately x% of remaining mortgage balance at the beginning of the month (less scheduled principal payment) will prepay that month:

    • Formula 11.2

    • One model that uses the CPR/SMM to estimate prepayment CFs is the Public Securities Association Prepayment Model (PSA Prepayment Model).


    Psa prepayment model
    PSA Prepayment Model

    • Is a series of monthly annual prepayment rates:

      • Assumes prepayments are low for new mortgages and will speed up as the mortgages become seasoned*.

  • PSA Model for 30-year mortgages:

    • CPR of 0.2% for first month increasing 0.2% each month for next 30 months (this is called seasoning).

    • When CPR reaches 6%, assume 6% per year for remaining years.

    • This is referred to as the 100 PSA Model (or 100% PSA Model).

  • Mathematically: (where t = # months since mtg originated)

    • Slower or faster speeds can be considered:

      • 50 PSA means 0.5 CPR, 150 PSA means 1.5 CPR, etc.


    100 psa model graphically
    100 PSA Model Graphically

    • Why does seasoning occur for 30 months?

      • Few people prepay when first purchasing a home.

      • However, the longer someone lives in a home the more likely someone may sell it (and thus prepay).


    Example of 100 psa model
    Example of 100 PSA Model

    • 100 PSA Model: page 251

      • Month 5:

        • CPR = 6%  (5/30) = 1% or 0.01

        • SMM = 1 – (1 – 0.01)1/12 = 0.000837

      • Month 20:

        • CPR = 6%  (20/30) = 4% or 0.04

        • SMM = 1 – (1 – 0.04)1/12 = 0.003396

      • Month 31-360:

        • CPR = 6% or 0.06

        • SMM = 1 – (1 – 0.06)1/12 = 0.005143


    Example of 165 psa model
    Example of 165 PSA Model

    • 165 PSA Model – Multiply CPR by 1.65: pg 251

      • Month 5:

        • CPR = 1.65  6  (5/30) = 1.65% or 0.0165

        • SMM = 1 – (1 – 0.0165)1/12 = 0.001386

      • Month 20:

        • CPR = 1.65  6  (20/30) = 6.6% or 0.066

        • SMM = 1 – (1 – 0.066)1/12 = 0.005674

      • Month 31-360:

        • CPR = 1.65  9.9% or 0.099

        • SMM = 1 – (1 – 0.099)1/12 = 0.007828


    Cautions using psa model
    Cautions Using PSA Model

    • Calling PSA Model a “model” may be a bit strong. It is really more market convention:

      • It is not based on rigorous statistical modeling of particular pool of mortgages.

      • Your text refers to it as the PSA Benchmark.

  • PSA Model is based on a study by PSA on FHA prepayment experience.

  • Using CPR is useful, but it does have many limitations*.


  • Factors affecting prepayments and prepayment modeling
    Factors Affecting Prepayments and Prepayment Modeling

    • A prepayment model is a statistical model used to forecast prepayments.

      • Wall Street firms and research firms have developed different prepayment models.

      • Firms usually use different models for agency and nonagency pass-throughs.

  • We will consider a prepayment model developed by Bear Stearns, (once) a major dealer in the mortgage market:

    • We will use this model to see if we can determine some factors that affect prepayment.


  • The bear stearns model
    The Bear Stearns Model

    • The Bear Stearns Model is an agency prepayment model.

    • The model consists of three components:

      • Housing turnover.

      • Cash-out refinancing.

      • Rate/term refinancing.


    Housing turnover
    Housing Turnover

    • Refers to existing home sales (not newly constructed homes)

    • 3 factors forecast prepayment due to housing turnover:

      • Seasoning effect

      • Housing price appreciation effect

      • Seasonality effect

  • *Seasoning effect:

    • B/S model suggests seasoning occurs much fast than PSA Model indicates (prepayments reach 6% CPR in 15 months, not 30 months)

    • Why? Refinancing waves. Age of loan < length of time owning home.

  • **Housing price appreciation effect:

    • As house prices increase there is greater incentive for cash-out refinancing.

  • Seasonality effect:

    • Home buying increases in spring and peaks in late summer (low in winter).

    • Prepayments follow this pattern because home sales cause prepayments.


  • Cash out refinancing
    Cash-Out Refinancing

    • Cash-out refinancing occurs when house prices increase:

      • Homeowners refinance not to get a better interest rate, but to get cash from equity of their home.

      • However, the rate of refinancing will depend not only on house prices, but also on the interest rate of new mortgages.

  • Bear Stearns model compares the pool’s WAC with the prevailing mortgage rates. The model suggests:

    • *Prepayments exist for WAC/Prevailing mortgage rate > 0.60.

    • Prepayments increase as WAC/Prevailing mortgage rate increases.

    • **The greater the price appreciation for a given ratio the greater the project prepayments.


  • Rate term refinancing
    Rate/Term Refinancing

    • Not all investors refinance to get cash out:

      • Some refinance to get a lower interest rate or a shorter term on their mortgage.

  • To capture this, the Bear Stearns model captures two potentially important dynamics:

    • Burnout effect – The fact that the lower interest rates go, eventually the slower the rate of refinancing (eventually everyone who can refinance has refinanced).

    • Threshold-media effect – as mortgage rates drop to historic levels, borrowers become more aware of these opportunities due to advertisements and media (again, eventually every who can refinance will, as rates decline).


  • Non agency cf estimation
    Non-Agency CF Estimation

    • Non-agency CF estimation must consider all of the attributes of agency CF estimation:

    • *However, one more issue must be considered:

      • Default and delinquencies (i.e., late payments).

  • A benchmark for default rates has been introduced by the PSA:

    • Called the PSA Standard Default Assumption (SDA) benchmark.


  • 100 sda std default assumption
    100 SDA (std default assumption)

    • From month 1-30:

      • Default rate in month one is 0.02%

      • Default rate increases 0.02% each month for 30 months (when default rate is 0.60%).

  • From month 30-60:

    • Default rate remains at 0.60%.

  • From month 61-120:

    • Default rated declines linearly from 0.60% to 0.03%

  • From month 121 on:

    • Default rate remains constant at 0.03.

  • Note, can also consider 200 SDA, 50 SDA, etc.



  • Cash flow yield
    Cash Flow Yield

    • Once a projected CF and pass-through price is calculated, its yield can also be calculated.

    • Recall from chapter 3 that the yield is the interest rate that makes the PV of the expected CFs equal the asset’s price:

      • A mortgage pass-through has a monthly yield which has to be annualized.

      • Recall that market convention dictates using the bond equivalent yield (i.e., multiplying the semiannual yield by 2).

      • However, mortgage pass-throughs have monthly yields, so to make them comparable to yields on semiannual yielding bonds we must:

    semiannual cash flow yield


    Caution using cf yield
    Caution Using CF Yield

    • Remember that CF yield is based on prepayment assumptions that may or may not be accurate.

    • Even if the assumptions are accurate, the CF yield will be realized yield only if the following are true:

      • Investor reinvests all CFs at the CF yield.

      • Investor must hold the pass-through security until all the mortgages have been paid off.


    Prepayment risks
    Prepayment Risks

    • Suppose an investor buys a 10% Ginnie Mae when mortgage rates are 10% and later mortgage rates decline to 6%.

    • Prepayments will increase. This creates two adverse consequences:

      • First, the Ginnie Mae price will rise, but not as much as an option-free bond would. That is the upside potential is truncated.

      • Second, the cash flow must be reinvested at a lower rate

      • Taken together these adverse effects are referred to as contraction risk.

  • Suppose mortgage rates increase from 10% to 15%:

    • Ginnie Mae will decline in price almost as much as an option-free bond (although not quite as much) because prepayments slow down.

    • Investors wish prepayments would increase and be reinvested at a higher rate.

    • Taken together these are known as extension risk.

  • Note: prepayments can sometimes enhance investor performance if bonds were purchased at a discount (see pp. 268-269)


  • Secondary market quotes of mortgage pass throughs
    Secondary Market Quotes of Mortgage Pass-Throughs

    • Pass-throughs are quoted in same manner as Treasury securities:

      • For example: 94-05 means 94 and 5/32 percent of face value.


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