The Super Fund owns the following two 30-year original maturity mortgage-backed

Question

The Super Fund owns the following two 30-year original maturity mortgage-backed securities shown in the table below. The fund uses the 10-year US Treasury yield as a relative measure to gauge the level of current 30-year home mortgage rates. Over the past four years, the 10-year US Treasury yield has declined below 5.50% three times, subsequently rising above 6.50 % each time. The 10-year US treasury yield is currently at 6.50%.

(a) Analyse the effect on prepayments of each of the following three factors: (i) coupon rate of the mortgage, (ii) age of the mortgage, (iii) seasonality

(b) Describe how principal prepayment risks is measured. Based on the table above which security will experience a higher percentage of principal prepayment? (5 marks)

(c) Appraise the reasons why prepayments are likely to be more stable for automobile receivables asset-backed securities when compared to similar-duration mortgage-backed securities. (6 marks)

Issue Coupon Weighted Avg
Maturity (Months) Price Current Month
CPR MBS-1 7.50% 355 100 5 MBS-2 7.50% 260 100 12

Explanation / Answer

PART A

Effect of coupon rate on prepayment rate: As the interest rates fall, the homeowners are more likely to refinance their mortgages or even purchase a new home to take the advantage of lower interest rates. This situation may lead to rise in higher prepayment rates. On the opposite side of the spectrum, if the interest rates rise homeowners would be discouraged to refinance the mortgage, which would result in lower prepayment rate.

Effect of age of mortgage on prepayment rate: Mortgage backed securities differ from bonds, bonds owners get their principal payment at the maturity date and meanwhile the receive interest payments. In case of MBS, every installment paid by the homeowner consists of the principal as well as the interest. Hence, in the early stages of the mortgage homeowners pay more interest than principal and thus are more susceptible to refinancing at early stages of a mortgage in the interest rates fall. But we must also consider the fact that refinancing involves transaction costs and hence homeowners are less motivated to refinance a newly financed mortgage.

Effect of seasonality on prepayment: It has been observed that house sales increase in summer and early fall season. It could be attributed partially to the fact that refinancing activity increases after the end of the tax year, thereby increasing the prepayment rates.

PART B

Prepayment speeds could be measured by using various models like CPR. CPR stands for Constant Prepayment Rate. It represents an annualized rate of prepayment speed. CPR could be calculated over varying time horizons ie 1 month,6 month etc. The higher the CPR , the faster the debtors prepay the loan. Hence, MBS-2 would have higher prepayment rate as its CPR is higher.

PART C

1>One reason for Automobile receivables asset-backed securities having stable prepayment rates is because the maturity of automobile loans is relatively shorter than mortgage backed securities, hence the debtor is discouraged to prepay.

2>The size of automobile loans is smaller as compared to mortgage backed securities hence the savinng opportunity is smaller for the debtor in case of automobile loans.

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