4. Mortgage Pass-Through Securities
e. describe types and characteristics of residential mortgage-backed securities, including mortgage pass-through securities and collateralized mortgage obligations, and explain the cash flows and risks for each type;
f. define prepayment risk and describe the prepayment risk of mortgage-backed securities;
What is a mortgage pass-through security?
A mortgage pass-through security is created when one or more mortgage holders form a collection (pool) of mortgages and sell shares or participation certificates in the pool.
In the U.S., what are the two sectors for securities backed by residential mortgages?
- Agency pass-throughs: Ginnie Mae, Fannie Mae and Freddie Mac.
- Non-agency, or private-label mortgage-backed securities
What does the cash flow of a mortgage pass-through security depend on?
The cash flow of a mortgage pass-through security depends on the cash flow of the underlying pool of mortgages and consist of monthly mortgage payments representing interest, the scheduled repayment of principal, and any prepayments, net of servicing and other fees.
What is a conditional prepayment rate (CPR)?
The prepayment rate assumed for a pool is called the conditional prepayment rate (CPR). It is based on a pool's characteristics (including its historical prepayment experience) and the current and expected economic environment.
What is a single-monthly mortality rate?
The single-monthly mortality rate (SMM) is the percentage of a pool's remaining principal that is expected to be prepaid each month. SMM is the conditional prepayment rate (CPR) converted from an annual term to a monthly rate.
What is the Public Securities Association Prepayment Benchmark?
The Public Securities Association Prepayment Benchmark is a schedule of prepayment speeds deemed to be "usual."
What is a Weighted Average Coupon (WAC)?
A weighted average coupon (WAC) is the weighted average of the mortgage rates of the mortgages in a pool, where each mortgage's weight is proportional to that mortgage's outstanding principal balance relative to the total of all the principal balances.
What is a Weighted Average Maturity (WAM)?
A weighted average maturity (WAM) is a weighted average of the remaining maturities of the mortgages in the pool, where each mortgage's weight is proportional to that mortgage's outstanding principal balance relative to the total of all the principal balances.
What is Contraction Risk?
Contraction risk is risk when interest rates decline and prepayments speed up. The timing of a pass-through security's cash flows is shortened.
What is Extension Risk?
Extension risk is the risk that when interest rates rise, prepayments will slow. The timing of a pass-through security's cash flows is lengthened.