Mortgage markets have developed significantly since the early 1970s through the

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?

Explanation / Answer

a) the cash flow of a mortgage, or a MBS is uncertain because the borrowers of the mortgages have the option to prepay the mortgage before its maturity therefore the investor of the MBS could receive the payment of the whole principal right before the maturity. Therefore there is uncertainty associated with the cash flows from the mortgage, or a MBS due to the uncertainty in the prepayment of the principal.

Mortgage cash flows are received which are fixed and are paid at regular intervals usually months ,the mortgages also pays a portion of the principal with each regular payment together with the interest therefore the regular fixed payment has both the interest and the principal components whereas the Treasury coupon bearing bond pay interest semi-annually, till the time of maturity only this interest is received and pays the principal only at maturity.

b) this call option depend upon the interest rates.The borrowers of the mortgage can refinance the mortgage in case the interest rate falls by exercising the option and prepaying the existing loan and refining with a lower interest rate loan.Threfore the call option is exercised or not depends on the level of interest rates.

c)the assumed prepayment speed necessary to price the MBS because there are bound to be prepayments which are uncertain,Therefore its necessary that the valuation of MBS consider these prepayments speeds because with that we can better estimate the amount and timing of cash flows as prepayments and thus we can better estimate the expected cash flows for the MBS and therefore accurately price them.

d) In terms of prepayment risk, contraction risk and extension risk, a PAC tranche of a Freddie Mac CMO issue with an average life of 2 years is appropriate.Since the average maturity of the PAC of 2 years closely matches with the liabilities duration of less than 1 year as compared to the Freddie Mac pass-through with a maturity of about 7 years.Also the PAC is less venerable to the prepayment risk upto an extent a support tranche absorbs the prepayment as compared to pass-through which is more venerable to the prepayment risk therefore PAC has lesser contraction risk than the pass-through.

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