Mortgage markets have developed significantly since the early 1970s through the
ID: 2721933 • Letter: M
Question
Mortgage markets have developed significantly since the early 1970s through the creation of secondary market instruments in the form of mortgage pass-throughs, collateralized mortgage obligations (CMOs), and REMICs. These collectively have been generally referred to as mortgage backed securities (MBS). In many ways, these instruments carry the characteristics of their underlying assets -- individual mortgages.
a. Why is the cash flow of a mortgage, or a MBS, uncertain in the sense that the investor in the mortgage has granted the borrower a call option to prepay the mortgage? Compare a mortgage cash flow with a Treasury coupon bearing bond paying interest semi-annually and a payment of principal at maturity.
b. What does this call option depend upon and why?
c. The cash flow for a mortgage pass-through typically is based on some prepayment speed benchmark. Why is the assumed prepayment speed necessary to price the MBS?
d. Suppose a bank has decided to invest in a MBS and is considering the following two securities: a Freddie Mac pass-through with a WAM of 340 months and an average life of 7 years or a PAC tranche of a Freddie Mac CMO issue with an average life of 2 years. In terms of prepayment risk, contraction risk and extension risk, which MBS would probably be best for the bank’s asset/liability management perspective when it is known that liabilities generally have a duration less than 1 year and that assets have durations in the 2-year to 7-year range?
e. Compare the interest rate risk of a noncallable 10-year Treasury coupon bearing bond with a mortgage-backed pass-through security with prepayments related to the level of interest rates – lower market interest rates raise the rate of prepayments. Discuss how the changes in cash flows from a mortgage-backed security affect the duration of such securities. HINT: consider the coupon effect on duration.
Macaulay Duration Measure:
where P = Price,
C = coupon,
F = Face value,
y = Yield to maturity,
M = maturity (years),
t = time (year),
dP is the total change in price,
Explanation / Answer
Answer:a To the extent credit risk is present in a mortgage. the cash flows are uncertain and thus unknown. Also, lenders have the option to prepay early adding further uncertainty to the cashflows over time.
Answer:b A call option gives the buyer of the option the right to buy the underlying asset at a fixed price, called the strike or the exercise price, at any time prior to the expiration date of the option. The buyer pays a price for this right. If at expiration, the value of the asset is less than the strike price, the option is not exercised and expires worthless. If, on the other hand, the value of the asset is greater than the strike price, the option is exercised - the buyer of the option buys the asset [stock] at the exercise price.
Answer:c A projection of assumed prepayment speed is necessary to determine the cash flow of the pass-through security in order to value a security. But the projection of cash flows require someassumptions about the prepayment rate over the life of a mortgage pool. The prepayment rate is called speed.
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