1. You are an instituational money manager looking to add some Ginnie Mae MBS to

Question

1. You are an instituational money manager looking to add some Ginnie Mae MBS to your portfolio. Consider the following statement statement made to you by a salesperson from broker-dealer Oldman Sax, who had attached the Bloomberg screen in an email:

"At the current price of 113-10, the calculated cash flow yield of 3.4788% represents the return that an investor is guaranteed to receive upon buying this mortgage-backed security." For each question, identify which of the following statements (A, B, C, D) is correct:

A. This statement is true because the guarantee made by the Ginnie Mae (full faith and credit of the US Treasury) against homeowner defaults is stronger than those provided by Fannie Mae and Freddie Mac.

B. This statement is true as long as the actual future prepayment experience matches the assumed prepayment speed (PSA of 285) that Oldman Sax typed into the calculator.

C. This statement is false: The actual return could be much higher i prepayments speed up (pay faster than PSA 285) in the future.

D. This statement is false: The actual return could be much higher i prepayments slow down (pay slower than PSA 285) in the future.

Explanation / Answer

Option B is correct.

The calculated yield is based on an assumption that all the borrowers will make the payment on time. If they start making default, risk of borrowing starts increasing, and the investors start increasing the required return due to increased risk. Therefore, the indicated return is based on an prepayment speed based on the previous experience.

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